Is Debt forgiven in a Short Sale Taxable?

My next post was supposed to tell you why loan modifications are a waste of time, but an attorney friend of mine in Rhode Island was confused about the tax consequences of the bank forgiving the debt shortfall. So tomorrow you will get the loan mod post.

Is debt forgiven in a short sale taxable or tax exempt?

The quick answer is debt forgiven on your primary residence is tax exempt, but you may have to file a form 982 with your tax return. Ordinarily any debt forgiven is treated as income by the IRS. However, H.R. 3648, The Mortgage Forgiveness Debt Relief Act of 2007 makes the debt forgiven on your primary residence non-taxable through 2012, in most instances.(check with a CPA or Accountant)

This is taken from the IRS.gov website:
Update Dec. 11, 2008 — The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief.

This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion doesn’t apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

The amount excluded reduces the taxpayer’s cost basis in the home. More details. Further information, including detailed examples, can also be found in Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.

If debt is forgiven for investment property or on any property other than your personal residence you still may be able to avoid paying tax on the forgiven debt. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt. The IRS wants to tax the forgiveness of debt the same as income. The IRS views income and debt forgiveness the same. However, if you incurred a loss through the sale of property equal to the amount of debt forgiven you may be able to offset the two and avoid any tax.

It is always best to check with a Certified Public Accountant. This advice is general and should only serve to help you ask your accountant better questions.