Posted on September 24, 2009 by Erin DeGeorge

DEBT FORGIVENESS: WATCH OUT FOR THE TAX CONSEQUENCES

In light of the current economic crises plaguing our country, your home may be on the brink of foreclosure, or will be sold by way of a short sale. You may also have staggering credit card debt. Therefore, when entering into a property settlement agreement that involves debt forgiveness (i.e. foreclosure, short sale, and reduction in credit card debt) it is critical that you choose a matrimonial attorney that is aware of the tax consequences associated with debt forgiveness because the financial impact can be enormous.

Historically, debt that was forgiven or cancelled by a commercial lender must be included as income on your federal and state tax return and was taxable. For example, if the total amount of the mortgage debt immediately prior to the foreclosure was $220,000 and the fair market value of the property was $200,000, the amount of the debt forgiven, $20,000, was treated as taxable income. Unless of course the borrower qualified for an exception under the Federal Tax Code, i.e., bankruptcy, insolvency, certain farm debt, and non-recourse loans.

On December 20, 2007, the Mortgage Debt Relief Act of 2007 (hereinafter referred to as “the Act”) was enacted. Said Act provides financially strapped homeowners with some relief in connection with treating debt forgiveness as income. Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on a principal residence that occurred in 2007, 2008 or 2009. Moreover, there is no dollar limit if the principal balance of the loan was less than $2 million ($1 million if married filing separately for the tax year) at the time the loan was forgiven.

What the Act does not do is provide relief to all forgiven or cancelled debt. Its application is severely limited to a forgiven or cancelled debt used to buy, build or substantially improve a principal residence or to refinance debt used for those purposes.

  • There is no relief for any debt forgiveness for a vacation or investment home.
  • There is no relief for credit card debt reduction.
  • There is also no relief available for cash-out mortgages whether the cash take-out takes the form of a refinanced first mortgage, a second mortgage, a home equity line of credit or similar arrangement.

For example, if an individual takes out a home equity line in the amount of $50,000 to pay off credit card debt then sells his home, via a short sale, for $300,000 but owes $350,000 on the first mortgage and $50,000 on the equity line used to pay credit card debt, the borrower will be required to claim the $50,000 as income on his federal income tax return. Moreover, the borrower will most likely be required to claim the entire debt forgiven, $100,000, on his state income tax return because the Mortgage Debt Relief Act only applies to federal income tax.

Why is this significant? This is significant because your principal residence, that has a cash-out mortgage, may be on the brink of foreclosures, or may be sold by way of a short sale. Or, your vacation home and/or investment properties may be in foreclosure or sold by way of a short sale. If that is the case, either a portion or all of the debt forgiveness will be considered taxable income. You will receive a 1099C from the lender and you will have to claim the debt forgiveness on your federal and state income tax return. If you are not yet divorced, a joint federal and state income tax return can be filed and an agreement can be reached as to how the tax debt associated with the marital property will be apportioned. However, what happens if you are already divorced and foreclosure or a short sale of marital property was not contemplated in the property settlement agreement? How are you going to deal with the tax consequences of the debt forgiveness? The party who received the 1099 and is compelled to claim the debt forgiveness on his or her federal and state income tax return will want the ex-spouse to share in the tax consequences. Most likely, the party who did not receive the 1099 will refuse to share in the tax debt, especially if it was a hotly contested divorce. Thus, it is imperative that debt forgiveness associated with your principal residence, vacation home, investment property, credit card debt reduction etc. be addressed in your property settlement agreement. Even if you and your spouse are solvent when the property settlement agreement is drafted, in today’s economy it is not a far fetched scenario that an individual could lose their job, be unemployed for a significant period of time, and have their home or homes sit on the market for a year or more with no offers in sight. That is a recipe for foreclosure or a short sale. By simply including a clause in a property settlement that addresses how the tax consequences of debt forgiveness will be treated in the event of same will alleviate a litany of post judgment applications.

The family law attorneys here at Fox Rothschild, LLP are well versed on these issues and can effectively assist you through this difficult time in your life.
 
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Posted on March 16, 2009 by Eric S. Solotoff

READ MARK ASHTON'S EXECELLENT POST ENTITLED "A REMINDER THAT THE WORLD OF BANKRUPTCY HAS CHANGED"

Mark Ashton, a partner in our Exton, Pennsylvania office, and the editor of the firm's Pennsylvania Family Law blog, wrote an excellent post on that blog entitled "A Reminder That the World of Bankruptcy Has Changed.   To see the full post, click here.

The post reminds us how the 2005 changes to the bankruptcy code affects divorce settlements.  Specifically, divorce settlements are no longer dischargeable in bankruptcy.  Under the prior Act, payments in the nature of support were non-dischargeable but equitable distribution could be dischargeable.  The court would apply a balancing test as to the debtor and former spouse.  That balancing test is now gone.

Very often we still see clauses in property settlement agreements proclaiming that the obligations are not dischargeable in bankruptcy or "are in the nature of support."  Those clauses do not seem necessary anymore. 

Given the current economy, this issue could be one we see a lot.  That said, bankruptcy does not seem like it will provide relief to former spouses.

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Posted on March 7, 2009 by Sandra C. Fava

APPELLATE DIVISION SAYS- MORE INFORMATION NEEDED TO DETERMINE DIVISION OF DEBT

In the recent unpublished Appellate Division matter of McDermott v. McDermott, A-0631-07T1, Decided February 20, 2009, the Appellate Division remanded the matter to the trial court for further proceedings on the amount of loans taken during the marriage from plaintiff's family and the distribution of responsibility for repayment of those loans.

The parties were married for nearly 30 years.  Plaintiff/husband was an attorney with a solo practice and defendant worked at his office for many years, helping to raise their five children and eventually finding employment outside the home with a local school district.  During the marriage, the parties primarily relied upon the income earned from plaintiff's law practice.  This income fluctuated throughout the years, in part due to the economy and in part due to plaintiffs bouts of depression.

During the 15 day trial in this matter, testimony was offered that during the course of the marriage, plaintiff made some unilateral decisions with regards to the parties' finances, including taking loans from his family and purchasing property without notifying defendant, who only found out during trial.  Defendant claimed that she only knew of very few of the loans given by plaintiff's family, however evidence submitted at trial indicated otherwise.  Plaintiff's sister offered credible testimony that the total amount of loans given was $283, 398.50 of which only $6,300 was repaid. 

After the trial, the trial judge issued a written decision, which in part, obligated defendant to repay plaintiff's sister the amount of $57,165.31 as her share of loans made to the marital partnership; valued plaintiff's law practice at $100,000 of which defendant was entitled to half; compelled plaintiff to pay $2,000 per month in limited duration alimony for a period of 6 years; and ordered plaintiff to pay $49,000 of the $80,202.70 counsel fees incurred by defendant in the divorce litigation.

 

Plaintiff appealed claiming that the trial court abused its discretion in requiring defendant to only repay 18% of the loans received from plaintiff's sister considering that defendant received almost 50% of the marital assets the loans preserved; the finding that plaintiff's law practice was valued at $100,000 was contrary to evidence and an abuse of discretion; the alimony award was contrary to evidence and an abuse of discretion; the counsel fee award was not based upon credible evidence, contrary to law and should be vacated; and the trial court's naked conclusions failed to explain many of its decisions therefore the plaintiff requested that the Appellate Division exercise original jurisdiction to decide the issues it reverses.

The Appellate Division affirmed the trial court's findings as to the value of plaintiff's law practice and its distribution, the alimony award and the counsel fee award.

As for the distribution of the loans made by plaintiff's family, the Appellate Division reversed and remanded the trial court's finding of the amount of loans subject to distribution for further proceedings on whether the marital partnership received and was benefited by other loans from plaintiff's family other than those specifically found by the judge. The trial judge found plaintiff's sister's testimony to be credible, however only specifically discussed distribution of two loans, totaling $120,000. Although the trial court's written opinion may be interpreted to have rejected plaintiff's arguments as to the remaining amount of loans taken, the Appellate Division would not base its decision upon such a loose interpretation and remanded for clear findings on this point.

On remand, the trial judge should consider principles established in the Appellate Division case of Monte v. Monte, 212 N.J. Super. 557 (App. Div. 1986) for dealing with marital debt. In Monte, the Appellate Division considered the equitable distribution of marital debt when "[t]he parties' affluent standard of living continued not only during periods of time when earned income was meager but also ...when plaintiff had no income because he was unable to work for over a year." Id. at 566. The amount of debt accrued during that time to sustain the family shall also be considered. The trial judge must consider whether, under the circumstances, defendant must have been aware that there were other loans, assuming there were, and whether they were used to preserve marital assets for her later benefit at the time of equitable distribution.

Lastly, the Appellate Division refused to accept original jurisdiction over the issues remanded. Plaintiff argued that because the trial judge had been moved out of the family division, the Appellate Division should retain original jurisdiction to prevent a new judge, unfamiliar with the case, from hearing the issues on remand. The Appellate Division has held that the transfer of a judge should not "interfere[] with what was required for a fair and just resolution of" a family court matter. O'Brien v. O'Brien, 259 N.J. Super. 401, 405-406 (App. Div. 1992). Despite being transferred from the family division, the trial judge has an obligation to decide the issues on remand and has been instructed to do just that.
 
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