If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the canceled amount as income for tax purposes. You should determine whether you will qualify for an exemption before your contemplated short sale or foreclosure closes. You may become obligated to the IRS instead of your lender!
Consider this, when you initially borrow money you are not required to report the borrowed money as income because you had an obligation to repay the lender. However, if all or a portion of that obligation is subsequently forgiven, the forgiven amount must generally be reported as income because you no longer have an obligation to repay the lender. The lender will then, generally, be required to report the amount of the forgiven debt to the IRS (1099-C) and you, in turn, report the forgiven amount as income and pay the related tax.
However, and fortunately, income associated with the forgiveness of debt may be excluded as taxable income if it falls within an exemption created by the Mortgage Debt Relief Act of 2007. The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007 (see IRS News Release IR-2008-17). Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence.
The Act only applies to debt that was forgiven or canceled in the calendar years of 2007 through 2012 and was used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes and the debt must be secured by the home. This is known as qualified principal residence indebtedness. The maximum amount you can treat as qualified principal residence indebtedness is $2 million or $1 million if married or respectively, filing separately. See your tax professional with regard to further detail and reporting requirements.
-Tisha Black-Chernine, Esq.
