How does the IRS determine a home value when calculating if tax payer was insolvent after "settling" a debt?

Question

I "settled" with several credit companies for over $40,000 in debt. The IRS considers the settlement amount as earned income unless the tax payer was "insolvent" at the time of the settlement. My home has minimal equity but I don't know how to determine the value the IRS will use in calculating my debt to income ratio. It could make a big difference in my tax liability for the past year but was better than filing for bankruptcy or losing my home. This question even seems to stump tax advisors. Any wisdom out there in Yahoo land would be appreciated.

Answer 1

Your insolvency is the difference of your liabilities and the fair market value of your assets just before your debt was cancelled.

Example 1: Home purchased for $100,000 with a $80,000 mortgage. Home is now worth $250,000 and your mortgage is $75,000. The only asset you have is your house. The only other debt you had was the credit card debt.

Liabilities: $75,000 + $40,000 = $115,000
Assets: $250,000

You are not insolvent, your net worth is $110,000.

Example 2: Same situation as above, but you have another $150,000 of debt owed in addition to the credit card debt.

Liabilities: $265,000
Assets: $250,000

You are insolvent $15,000. You must include $25,000 of the debt forgiveness in income.

Obviously your situation will be much more complicated and you need a tax professional to assist you if you want to reduce your taxable cancellation of debt through insolvency.

Answer 2

The IRS determines solvency based on your total debts minus your total assets at fair market value. When you have debts forgiven, the total amounts forgiven are added to your assets, and any positive amount becomes taxable.

There are seven things you're allowed to deduct from these taxable amounts:

Net operating losses and carryovers (if you have a business)
General business credit carryovers (not deducted last year because of limitations)
Minimum tax credits
Capital losses and carryovers
Basis of taxpayer's property (the equity in your home)
Passive activity losses and carryovers
Foreign tax credit carryovers

You have a small window of opportunity to prove that your home is worth less than they claim, if that's what you think, but you have to sell your home to prove it. "Fair Market Value" is whatever price the market will bear and it serves as a more reasonable valuation than any estimate unless it's an obvious bargain sale.

(In reality, I think you've stumbled upon a contradiction in the tax code. Taxes are supposed to be paid on a cash basis, in other words you pay as you go, you pay when you have the wherewithal to pay. In your case, you're being forgiven debts that you don't have the wherewithal to pay, yet your being asked to consider it income as if it were in your bank account. On these grounds, you should ask for a payment plan with no interest or penalties applied.)

Answer 3

Any wisdom?

Yes, get the best CPA and/or Tax Atty you can. Cudos on what you've done so far, but you're in a "jungle" and you need a "jungle guide" or you're gonna get killed.