Taxation on Mortgage Debt Cancellation

As a result of the current real estate market in Arizona, many homeowners are losing their homes either through foreclosure or a short sale.  There can be income tax consequences for either of these transactions.  When a property is foreclosed on or sold through a short sale there are two tax issues that must be addressed: (1) the cancellation of any indebtedness; and (2) the sale or disposition of the property. 
Many people understand that there is tax relief under certain circumstances for cancelled mortgage indebtedness.  However, they often fail to realize is that the transactions are also treated as sales for income tax purposes and a gain or loss on the transaction must be calculated.  Determining any taxable amounts for the sale of the property and the debt cancellation is often difficult.  It requires strict financial calculations, knowledge of the income tax code and diligence in completing the required tax forms.
The general rule is that debt forgiveness is a taxable event.  Some exceptions to this rule include bankruptcy (Title 11), qualified farm indebtedness, insolvency and certain qualified real property business indebtedness.  But under the Mortgage Forgiveness Debt Relief Act of 2007 (enacted on 12/20/07), many taxpayers may be able to exclude qualified principal residence indebtedness if the balance of their mortgage was less than $2 million (or $1 million for a married person who files a separate return).
There are some exceptions to debt forgiveness under the Act.  Debt that is forgiven through a short sale, a principal balance reduction, as well as mortgage debt forgiven in connection with a foreclosure may qualify for this relief.  Debt forgiven on a rental property, auto loan, second home, business property, or credit cards will not qualify under the new provision. In some situations other relief is available.
If only a part of the loan is qualified principal residence indebtedness, the exclusion applies only to the extent that the amount discharged exceeds the amount of the debt (immediately before the discharge) that is not qualified principal residence indebtedness. For example, assume the principal residence is secured by debt of $300,000, of which $225,000 is qualified principal residence indebtedness. If your residence is then sold for $200,000 and $100,000 of debt is discharged, only $25,000 of the debt discharged may be excluded from income (the $100,000 that was discharged minus the $75,000 of nonqualified debt). The remaining $75,000 of nonqualified debt may qualify in whole or in part for one of the other exclusions, such as insolvency.
If a homeowner is not able to exclude all debt cancellation based on the Act, there may be relief if they can prove they were insolvent.  You are insolvent when, and to the extent, your liabilities exceed the fair market value of your assets. Determine your liabilities and the fair market value of assets immediately before the debt cancellation to  determine  whether  or  not  you  are insolvent  and  the amount by which you are insolvent. 
For purposes of determining insolvency, your assets include the value of everything you own (even including any assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as  pension plans and the value of any retirement accounts). Liabilities include the entire amount of recourse debts and the amount of any nonrecourse debt that is not in excess of the fair market value of the property that is security for the debt. You can exclude  from  your  gross  income  debt  canceled  when  you  are  insolvent,  but  only  up  to the  amount  by  which  you  are  insolvent. 
If you had a foreclosure or short sale during the year, you will most likely receive a Form 1099-A or 1099-C as a result of the transaction.  By law, this form must show the amount of debt cancellation and the fair market value of any property given up through foreclosure. You must review any 1099 carefully and notify the lender immediately if any of the information shown is incorrect.  Pay particular attention to the amount of debt forgiven and the value listed for the property. 
You should review your 1099s with a CPA to determine if any of the debt cancellation can be excluded from taxable income.  In some situations, you may need to determine whether you were insolvent at the time of the debt cancellation.
Paul B. Sundin, is a CPA in Gilbert, Arizona.  He provides assistance to taxpayers going through a short sale, foreclosure, or a deed in lieu.  Please see his website at www.sundincpa.com or you can contact him at 480-626-8043.  This article is written for informational purposes only and is not meant to be tax advice.  To ensure compliance with the requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.