Debt Forgiveness and Taxation

One of the most important laws regarding short sales is the Mortgage Forgiveness Debt Relief Act of 2007.  Specifically, this law applies to short sales because the lender has forgiven or canceled debt, and now the seller may have taxable income.  The IRS says:

If I sold my home at a loss and the remaining loan is forgiven, does this constitute a cancellation of debt?
Yes. To the extent that a loan from a lender is not fully satisfied and a lender cancels the unsatisfied debt, you have cancellation of indebtedness income. If the amount forgiven or canceled is $600 or more, the lender must generally issue Form 1099-C, Cancellation of Debt, showing the amount of debt canceled. However, you may be able to exclude part or all of this income if the debt was qualified principal residence indebtedness, you were insolvent immediately before the discharge, or if the debt was canceled in a title 11 bankruptcy case.

Since a short sale involves forgiveness of debt (the amount written off as a loss by your lender), sellers may receive a 1099-C from the short sale lender.  In other words, the forgiven debt amount becomes taxable income.  However, the Mortgage Forgiveness Debt Relief Act and Debt Cancellation provides for an exception for qualified principal residences.  In essence, the forgiven debt may be excluded from the seller’s income.  So what does “exclusion” mean?  According to the IRS website:

Normally, debt that is forgiven or cancelled by a lender must be included as income on your tax return and is taxable. But the Mortgage Forgiveness Debt Relief Act allows you to exclude certain cancelled debt on your principal residence from income. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

Additionally, there is an exception for insolvency.  Again, quoting from the IRS website:

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.

So what does all this mean?  Quite simply, it illustrates the necessity of an attorney in any debt reduction scenario, be it a short sale, foreclosure, deed-in-lieu, loan modification, etc.  Every seller’s situation is different, but in all cases, a seller should consult with an attorney or tax professional.  The good news is that there may be relief from the tax effects of a short sale.  To find out about your particular situation, consult an attorney or CPA at the beginning of the process, not at closing!

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