Normally cancellation or forgiveness of debt is considered income in the year that it occurs. In 2007 congress enacted legislation that exempted personal home mortgage debt cancellation making this tax exempt income. Applies to qualified debt cancellation or forgiveness on principle residences between1/1/07 and 12/31/12.
To be eligible it must be debt on one’s personal residence, the debt must have been used to acquire or improve the personal residence. The exclusion cannot exceed $2 million.
Circumstances that may create debt cancellation or forgiveness:
Loan Modifications will result in some loan forgiveness generally as a result of an interest rate reduction, but could be a principle reduction.
A foreclosure doesn’t always mean that the debt has gone away. Once the property is sold the proceeds less selling costs will be deducted from the amount owed. Most of the time a balance remains on the original debt. The financing company may or may not forgive this loan balance. If the debt is forgiven then it may qualify for mortgage debt forgiveness.
Bankruptcy may also cancel debt and may be eligible for exclusion.
For additional information you can check these out.
http://www.irs.gov/newsroom/article/0,,id=184704,00.html
http://www.irs.gov/pub/irs-pdf/p4681.pdf
Thanks for the info Charles. Can you tell me how it works with Short Sales? I seem to be doing a lot of them lately.
A short sale may create debt forgiveness as well. The financing company will decide if they want to go after the home owner for the remaining balance. If they decide not to go over the remaining balance the debt is considered forgiven and may be eligible for income tax exclusion.
Thanks for clarifying for me Charles. I was getting mixed answers on that.
Charles - I was just talking about this with my broker today. Here in Arizona, it was her understanding that the lender cannot go after the individual for the forgiven balance in a short sale. I forgot what it was called, but she said it was due to the type of state we are in regards to owning property.
It seems difficult to get an exact answer for this, as it may depend on what state you work in, as well as who you talk with. I wish I knew what resource to go to in order to get a definitive answer.
States can enact their own regulation here and it can be part of the agreement at time of sale. In Washington State a homeowner could still ending up owing the balance.
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