If you ditch your husband, don't stick him with your debt-forgiveness tax. Carsten Hoffmann is a managing director of FMV Opinions, a valuation and financial-advisory services firm.

In happier times, and wearing rose-colored glasses, the Stevenses took a $256,000 loan and purchased a dilapidated investment property in Chicago. He was going to bring the place up to snuff and she was going to smile and hand him cold glasses of lemonade.

Soon enough, however, the couple came to realize that they could neither stand each other nor afford to make payments on the property. Rather than falling into foreclosure and ruining their credit, they entered into a short-sale agreement with the lender and, in 2003, found a buyer willing to purchase the property for $200,000.

Problem

Though the lender had informed the Stevenses that they would report the discharge of indebtedness to the Internal Revenue Service, and had mailed separate letters to Mr. Stevens and his now ex-wife informing them of the exact dollar amount involved, neither reported the discharged indebtedness as income on their tax return.

Generally, a taxpayer has to include income from the discharge of indebtedness under Section 61(a)(12) of the income tax regulations. However, there are possible exceptions to this rule. Section 108(a) provides that a taxpayer may exclude income from the discharge of indebtedness if the discharge occurs in a bankruptcy case, or when the taxpayer is insolvent, or if the indebtedness is qualified farm or business real-estate debt.

Because the record was void of any evidence that would have allowed the Stevenses to take advantage of these possible exceptions, the Tax Court held that the tax deficiency related to the indebtedness was owed. In addition to that, the Court also held that under Section 6662(a)'s "Accuracy-Related Penalties," Mr. Stevens owed the imposed 20% penalty tax in addition to the deficiency. The argument that Mr. Stevens had relied on his ex-wife to report the income from the indebtedness didn't hold water with the court.

Summary

Given the phase of the real-estate cycle we're in, the issue of indebtedness forgiveness is likely to continue resurface. Not just in the context of the fixer-upper but, more importantly, in the context of major real-estate holding companies or developers that need to re-negotiate their debt. In many of those cases, the Section 108(a) exceptions may very well apply, and those organizations will need thorough appraisals to quantify the amount that can be excluded from treatment as taxable income.

The second lesson, of course, is that you shouldn't rely on your ex-spouse to pay your taxes.

On that side of things though, the court did say that Mr. Stevens could look to civil remedy against his ex-wife, as they owned the property as joint tenants and should be equally responsible for declaring the income tax. -FWR

This is not intended or written to be used by any taxpayer or advisor to a taxpayer for the purpose of avoiding penalties that may be imposed upon the taxpayer or advisor by the IRS. This writing is not legal advice, nor should it be construed as such.

.