If you can show that you were insolvent at the time this goes through foreclosure, then you would not have to pay taxes on this canceled debt.
To show insolvency, you would fill out a worksheet provided by the IRS that lists all of your assets and your liabilities. But you would include in that worksheet the current value of the land and the current amount of the debt that you owe, so if the land is worth $200,000 less than what you owe on the note, and you only have another $60,000 in assets, then you should be able to exclude at least a major portion of this debt from being taxable,if not the entire amount.
The amount by which you are insolvent is the maximum that you can exclude from being taxed. So if the amount of the forgiven debt ends up being $200,000, you would have to show that you were insolvent by at least that same amount in order to exclude the entire amount. If you were insolvent by the amount of $160,000, then $40,000 of the canceled debt would still be taxable.
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Thank you James
Hello again James,
The value of the land would be included as one of your assets. But then the amount you owe on the land would be included as one of your liabilities. So right there you are at the even point if the land sells for less than what you owe on it. So your other assets and liabilities outside of the land and the note on the land need to net out to zero or less.
And yes, you can and should include credit card debt or any other debt you have such as car loans, home mortgages, or any other legally enforceable debt that you owe.
As far as whether it is better to do a short sale or foreclosure, the tax consequences will be treated in the same manner. And you do not need to file this before next year. If you plan to try and use the insolvency exclusion, that option has always been available to taxpayers, and will continue to be unless the law changes at some point. But I honestly do not see that being one law that would likely change.
As far as being audited, I do not particularly see this as a huge risk. With the economy being the way it has been for the last couple of years, the IRS is seeing a marked increase in the number of people with canceled debts, and the great majority of them are claiming exclusion either due to insolvency or bankruptcy. So I do not think this would be a particular risk for you.
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Thank you again James