Cancellation of Debt & Possible Tax Liability for Short Sales

The following information on Mortgage Forgiveness Debt Relief Act was obtained from the IRS website. Only the sections relevant to foreclosures and loan modifications have been included. For more information, go to www.irs.gov. See also Publication 4681 for further details.

If you owe a debt to someone else and they cancel or forgive that debt, the canceled amount may be taxable. The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through loan modification, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

For information regarding your specific situation please consult a tax specialist.

What is Cancellation of Debt?
If homeowner borrows money from a commercial lender and the lender later cancels or forgives the debt, they may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When they borrowed the money they were not required to include the loan proceeds in income because they had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount the homeowner 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 the homeowner and the IRS on a Form 1099 Cancellation of Debt.

Is Cancellation of Debt income always taxable?

Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:

• 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 the homeowner is insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to them. If they are insolvent when the total debts are more than the fair market value of your total assets.

• Certain farm debts: If the homeowner incurred the debt directly in operation of a farm, more than half their income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, their 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 the homeowner 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.

Jeff Coga aka "The Short Sale Samurai"

www.ShortSalesBuyers.com

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