The Tax Implications of Forgiven Debt

Losing a home to a foreclosure or short sale most often comes at a time of great financial hardship. Often, when a home is sold because the bills cannot be paid, the money raised by the sale is used to pay down the mortgage debt and whatever debt remains is usually forgiven.

The tax implication of forgiven debt is often overlooked by those in an already difficult situation. It is not forgotten by the Internal Revenue Service (IRS). The IRS treats forgiven debt as income, including debt forgiven after a foreclosure or short sale.

In 2007, however, the Mortgage Forgiveness Debt Relief Act was passed, which states that forgiven mortgage debt will not be taxed by the IRS when a home is sold in foreclosure or short sale, with a few exceptions.

The exceptions to the Act, as explained by CNNMoney, are:

  • Cash-out refinance - If cash from a refinanced loan is used for purchases or spending unrelated to the home or home improvements, the IRS may consider that portion of the forgiven debt as taxable income.
  • Home-equity lines of credit - Similar to refinanced mortgages, home-equity lines of credit that are forgiven may be considered taxable income by the IRS if that debt was used for purchases or spending unrelated to improving the home.
  • Vacation and investment property - Forgiven mortgages on homes that are not used as a primary residence for two of the previous five years will be treated by the IRS as taxable income.
  • Homes worth several million dollars - The Act only allows for the first $2 million of a forgiven mortgage to go untaxed.

There are also exceptions to the exceptions of the Act, however. As Kent Anderson, a tax expert, told CNNMoney, if a debtor is insolvent when the mortgage was foreclosed upon or if the mortgage debt is forgiven through bankruptcy, then the forgiven debt will not be considered taxable income.

If you are facing the loss of your home through short sale or foreclosure, speak with a Chicago consumer lawyer who can help you through the entire process.

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