Normally, debt forgiveness results in taxable income, but under the Mortgage Forgiveness Debt Relief Act enacted in 2007, taxpayers may exclude debt forgiven on their principal residence if the balance of their loan was less than $2 million. This law applies to debt used to buy, build or substantially improve a principal residence or to refinance debt incurred for those purposes (usually purchase-money loans) and is in effect until 2012. Debt used to refinance a principal residence qualifies for the exclusion, but only to the extent that the principal balance of the previous mortgage would have qualified. Borrowers who have debt forgiven will receive a Form 1099-C from their lender. To qualify for the exclusion, Form 982 must be completed and filed with your tax return.
For second homes (non-principal residence) and non-purchase money loans not used to improve the property, the Mortgage Forgiveness Debt Relief Act does not apply. However, the forgiven debt may qualify under the insolvency exclusion. Normally, you are not required to include forgiven debts in income to the extent that you are insolvent. You are insolvent when your total liabilities exceed the total fair market value of your assets. (Insolvency is NOT bankruptcy.)
For investment properties sold via short sale, the difference between the property’s adjusted basis (purchase price including adjustments over time) and the sale price creates a deductible loss which can be used to offset the “gain” of the forgiven debt. Keep in mind that the outcome is exactly the same from a tax perspective whether the property was foreclosed upon or sold via short sale.
To determine the tax liabilities that will apply to your particular circumstances, please consult a CPA.
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