May 04, 2011

Short Sales, Foreclosures, and Debt Forgiveness

The present economic environment has led many folks to lose their homes because of inability to satisfy their mortgages. Transactions take several forms, but foreclosures and short sales have become fairly common. While homeowners typically think of these deals as giving rise to a "loss," such is not always the case for tax purposes.

Generally speaking, a taxpayer realizes some form of income when a debt is cancelled, forgiven, or reduced by the lender. And lender actions of this nature often come into play when a taxpayer restructures the acquisition debt on his principal residence, loses a principal residence in a foreclosure, or sells his principal residence in a short sale.

But the Mortgage Relief Act, effective for debt discharged on or after January 1, 2007 and before January 1, 2013 generally allows taxpayers to exclude up to $2 million of such mortgage debt relief associated with their principal residence. The tax return for the year in which an event of this kind takes place should contain IRS Form 982, "Reduction of Tax Attributes Due to Discharge of Indebtedness". Though income may be excluded, the price of this favor bestowed by the IRS is reduction of the basis in the principal residence (though not below zero). More information from the IRS on cancelled or forgiven debt is here.

Note that these provisions relate only to one's principal residence -- there will be no exclusion for debt forgiven with respect to a vacation or second home, business property, or rental property.

Also, the mortgage debt exclusion may not fully apply in the case of a mortgage which has been refinanced. Refinanced principal residence debt is eligible for the exclusion up to the amount of the previous mortgage before the refinance.

And there may be further complications in any given situation -- don't confuse the issue of debt reduction (and how it's taxed) with any actual gain which might still arise on the sale of the house. In short sales, taxpayers might sustain gain from the sale of the property instead of or in addition to income from discharge of debt. Of course, another rule (IRC Section 121, allowing some joint filers to exclude gain of up to $500,000 on sale of their residence) might exempt some or all of such gain. It gets complicated. Do-it-yourselfers beware.

Learn more in Nolo's article Canceled Mortgage Debt: What Happens at Tax Time?