I am often asked by clients what the tax implications are should they choose to pursue a short sale or their property is the subject of a foreclosure. Technically, and they’re right. Debt obligations that are forgiven are usually counted as income to that individual. For example, if you obtain a home loan for $300,000 but sell the property via the short sale process for $200,000, that $100,000 difference that you are no longer required to pay would be taxable as income under normal circumstances. In 2007, the federal government passed the “Mortgage Forgiveness and Debt Relief Act.”

The IRS describes it as follows:

“If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.”

Cancellation of Debt is not always taxable, however. According to the IRS there are some exceptions:

–Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
–Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
–Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
–Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.
–Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences

See Publication 4681.

The Mortgage Forgiveness Debt Relief Act of 2007 allows homeowners who have benefited from debt cancellation—usually from a short sale, deed-in-lieu of foreclosure, or foreclosure—to exclude the “income realized” from the forgiveness. Exclusion of income resulting from a cancellation of debt means that the amount forgiven or waived from the creditor (usually a bank) is not considered income and is excluded from determining your federal income tax basis.

Going back to the example in the first paragraph, the $100,000 debt that was cancelled would be excluded from that individual’s income of that year. In a normal year (without the Act in place), if that person made $50,000, but was forgiven $100,000 through a short sale, he or she would be required to include that sum as income for that year, making his income $150,000 and subject to the corresponding tax rate. Because that $100,000 is excluded from his income by virtue of the Mortgage Forgiveness Debt Relief Act, his tax rate is preserved at the $50,000 level.

The above information can be found at the following link: http://www.irs.gov/individuals/article/0,,id=179414,00.html

I would also refer you to an in-depth review of the law at http://www.homesalessandiego.com/blog/mortgage-debt-forgiveness-law/.

*Lawyers at Dickson Steinacker, PS are NOT tax specialists. Federal income taxes are a serious matter and should be dealt with through counsel from a qualified accountant or tax attorney. Because much of our business deals with real estate issues such as short sales, foreclosures and loan modifications, we feel it is important to be cognizant of the broader implications of debt cancellation (hence, the above blog entry). If you are in need of more detailed/specific guidance for your tax matters, we recommend contacting a tax attorney or qualified accountant. Do not rely solely on this entry for your tax strategy.