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Income Tax Effects from Debt Forgiveness--The Playing Field May be more complex than most people realize

By
Services for Real Estate Pros with Topkins & Bevans-etopkins@topbev.com

I read a column in the Business Today section of the Boston HERALD on Sunday, March 13, 2011, which I found both upsetting and surprising and not in accord with my prior understandings. Perhaps, some of you also read Kenneth Harney's column on the real story of the treatment of debt forgiveness by the Internal  Revenue Service,  when there is a short sale or foreclosure. To be perfectly honest, I was more shocked than anything else to discover that there were real "strings" to debt forgiveness, even if the property involved is, or was, your personal residence.

There is an exemption for excluding the amount of debt forgiven from being counted as ordinary income but only to the extent that the debt involved was used to "buy, build or substantially improve your principal residence". What this says to me is that if you, at some juncture, refinanced your home to pay off credit card debts or buy a car or pay tuition, the amount of money so used for that purpose may be treated as ordinary income by the IRS, when you obtained relief form that debt.

Many people took advantage of rising home values to take money out of their home for various purposes. If those purposes did not fit into the definition set forth above, those very same people may be looking at some serious tax consequences that they had not considered when they let their home go to foreclosure, or worked on a short sale.

I am not a tax attorney; I am a real estate attorney. This post is not meant to provide tax advice. You should consult your own tax advisor for tax information. I just thought that the information contained in Kenneth Harney's article is relevant to us, as  real estate professionals,  and may affect our clients. It is for that reason alone that I thought it appropriate to bring the column to your attention

Comments (9)

Andrew Mooers | 207.532.6573
MOOERS REALTY - Houlton, ME
Northern Maine Real Estate-Aroostook County Broker

Good advise and nice to have a resident legal beagle in the AR fraternity house.

Mar 15, 2011 05:48 AM
Reba Haas
Team Reba of RE/MAX Metro Eastside www.TeamReba.com - Bellevue, WA
Team Reba, CDPE

You are correct, I've sat in on several presentations from attorneys who deal with tax issues and bankruptcy and learned a few years ago that this is the case. When considering short sales and foreclosure actions, we always refer sellers to an attorney so they can have this situation reviewed. I've had some short sales fail once the property owner realized they may end up with major tax issues although I'm not sure why they thought it would be better in foreclosure because in some cases the 2nd lien holder can still pursue judgments and there is the chance of tax payments being required for the write off.

Sellers, do yourself a favor and go see an attorney (one who specializes in tax/bankrupcy/short sales) to get advice on these matters!

Mar 15, 2011 05:59 AM
Gene Mundt, IL/WI Mortgage Originator - FHA/VA/Conv/Jumbo/Portfolio/Refi
NMLS #216987, IL Lic. 031.0006220, WI Licensed. APMC NMLS #175656 - New Lenox, IL
708.921.6331 - 40+ yrs experience

I saw an article that covered much the same topic here in Chicagoland this last week.  It really caught my attention, because as you state ... it's not quite the take I had on this issue.  Needless to say, it's becoming more and more important for specific qualified professionals be utilized that will know and understand your personal scenario.  Having a generalized background no longer gets the job done well enough.  Referring clients to the properly-educated and qualified professional is a must.  This just proves it beyond a shadow of a doubt ...  good info to pass on, Elliott.

Gene

Mar 15, 2011 06:29 AM
Conrad Allen
Re/Max Professional Associates - Webster, MA
Webster, Ma, Realtor

Hi Elliot - Your blog advances the cause for a flat tax.  The IRS code is a swamp of misunderstandings.

Mar 15, 2011 01:50 PM
Leslie Ebersole
Swanepoel T3 Group - Saint Charles, IL
I help brokers build businesses they love.

Hi Elliott: our broker put a stack of copies of of the Ken Harney article in our central work room. Too many agents are too flip about the advantages of a short sale. I see lawsuits in the future from home sellers  that may be able to prove they were misled by an under-informed real estate agent. 

Thanks for posting this,

Mar 15, 2011 04:13 PM
FN LN
Toronto, ON

Hi Elliott - I had not examined this particular part of the Code recently so thanks for highlighting some of the exemptions relating to this income inclusion issue.

Mar 15, 2011 06:49 PM
Elliott S. Topkins
Topkins & Bevans-etopkins@topbev.com - Boston, MA
Massachusetts Real Estate and Title Atty

Leslie--Great hearing form you again. I think there is a lot of "once over lightly" with short sale disclosures to sellers. i agree that there may be a day of reckoning.

Mar 15, 2011 11:27 PM
Ann Bellamy
Hard money lending for investors in NH and MA - Tyngsboro, MA
Lending to real estate investors since 2006

Another example of you don't know what you don't know.  I think many people in short sale situations may not have the money for a tax accountant or tax attorney.

Mar 16, 2011 01:50 AM
Andrea Swiedler
Berkshire Hathaway HomeServices New England Properties - New Milford, CT
Realtor, Southern Litchfield County CT

Elliott, this just makes my head spin. Thank you for the heads up. Honestly, things keep getting worse and worse.

What appears to be the right thing to do may not be at all. But how do I know.

Mar 17, 2011 12:11 AM