I felt that this is important to write about because so many people don’t realize that forgiven debt is taxable income. So what is forgiven debt and how does it relate to real estate? Let’s say that you short sale your home in order because you have to move and the house isn’t worth as much as it used to be and you can’t get for it what you still owe on the loan. Say you owe $250,000 and you do a short sale for $200,000. That $50,000 difference is forgiven debt. You don’t owe it anymore and the bank has taken the loss for you. Well, in walks the IRS. They believe that forgiven debt is taxable income. Whoa! You lost money, you’re out of your house, and now you owe the IRS?
Yes. It’s that simple. However, in 2007, Congress created legislation to avoid this in some circumstances. As long as the loan was used to purchase or improve the home owner’s primary residence, the IRS had to exclude up to $2 million of that forgiven debt from taxes. So that’s the good news. But beware: This legislation is currently set to expire in 2012. So if now begins the time that you’re starting to fall behind on payments, unless the legislation is renewed, you could owe on it in 2012 or further into the future. And if the bank sends you a tax form 1099-C because of forgiven debt, it’s crucial that you inform the IRS that you’re eligible for this Congress-enacted exclusion. Otherwise, they can tax you for it.
It’s also important to realize what else is considered taxable debt and IS NOT included in the exclusion. This debt will be taxable:
1. Credit card debt. If you negotiate with your card company to reduce the amount you owe, any amount that gets forgiven is taxable.
2. Mortgage debt from a second home. The exclusion only applies to your primary residence. If you lose a vacation house, income property, or second home because of foreclosure, the difference is taxable.
If you’re really in a bind, you can choose to file for bankruptcy. Any debt that’s forgiven that stems from a bankruptcy is not taxable. If you have further questions, please contact a CPA to guide you through that and any other tax process. I can be reached via my Web site.