Debt Forgiveness On "Short Sales" Not Always Subject To Income Tax

An article by syndicated columnist Kenneth Harney (reported in The Ledger, of Lakeland, Florida) describes the income tax "hand grenade" that homeowners in default on their mortgages face when mortgage lenders agree on either a mortgage modification or a "short sale" where, as part of the deal, the mortgage lender agrees on forgiving part of the mortgage debt. Under general income tax rules, the part of a debt that is forgiven is subject to Federal income tax (and state and local income taxes, if applicable, as well). Such a tax generally causes a problem for a homeowner because he/she is not actually receiving money to pay the tax with. Further, since these situations typically arise with financially strapped people, they usually don't have any other source of cash to pay this tax with.

Reportedly, proposed legislation in Congress could soften some of the impact on financially stressed homeowners, however. The Mortgage Cancellation Tax Relief Act of 2007 (HR 1876), if ultimately passed by Congress and signed into law, would amend the tax code to exclude debt forgiveness on principal home mortgages from treatment as income.

For more, see The Tax Man Will Care About Your Forgiven Debt.

For those who can't wait that long, I will point out that there are a number of exceptions and exclusions to this income tax rule. Among the exceptions and exclusions are:

• debt that would have been deductible if paid,
• debt that is canceled as a result of Hurricane Katrina,
• debt that is canceled in a Federal Bankruptcy case,
• debt that is canceled while you are insolvent, but limited by the dollar amount of your insolvency,
• and others.

I suspect that many financially strapped homeowners losing their homes may, in fact, be insolvent. I also suspect that, because there doesn't seem to be much written about the insolvency exception (or the other exceptions, either) to the general rule, it is probably being overlooked by many people. To read more about all the exceptions and exclusions to the general rule that subjects an individual to income tax on the amount of debt that is forgiven, see:

• Section 108 of the Internal Revenue Code,
• IRS Publication 4681: Canceled Debts, Foreclosures, Reposessions and Abandonments.

If you need assistance in determining whether or not you qualify for one or more of the exceptions or exclusions, I highly recommend retaining the services of an experienced tax professional who knows something about doing some basic tax law research (ie. tax attorney, CPA, or Enrolled Agent; this is not a job for your average tax form preparer). And be prepared to show the tax pro copies of the three references listed above, just in case.

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(revised 5-9-07; 1:12 pm)

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