In a special area on its Web site (in a Q&A on home foreclosure and debt cancellation), the Internal Revenue Service advised, “Insolvency can be fairly complex to determine and the assistance of a tax professional is recommended.”Also, in recognition of the important role that the “insolvency exception” plays in excluding a beleaguered homeowner’s forgiveness-of-indebtedness income, the site further advised, “Consider the tax consequences before foreclosure.” This article explores what planning can be done to maximize the use of the insolvency exception to reduce or eliminate forgiveness-of-indebtedness income for the individual caught in the current mortgage financing or similar credit squeeze.

The rules on income from debt forgiveness under Code Sec. 108 usually keep a low profile, quietly being applied without much controversy. Every so often, however, a crisis brings the rules front and center, and with them comes debate over their finer points. Many homeowners now in trouble as a result of mortgage resets and plummeting home values are hanging their hats on the Mortgage Indebtedness Relief Act (which was still pending at this article’s deadline). However, even if it passes, many homeowners will not find relief under the new legislation, but should look to existing law — and particularly to the insolvency exception — in planning damage control.

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