In 2007, Congress enacted the Mortgage Forgiveness Debt Relief Act. It was designed to remove the negative tax consequences of a short sale, deed in lieu of foreclosure, or consent foreclosure. In general, when a creditor forgives a debt that you owe, the IRS considers that forgiven debt to be untaxed income. If the creditor issues a Form 1099, then you must report the forgiven debt on your taxes.
For people seeking a short sale, deed in lieu, or a consent foreclosure, this law provided serious protection from the tax consequences of a forgiven debt. So many houses are so far underwater that a forgiven deficiency could be over $100,000.00. That means that the homeowner would be on the hook for six figures of untaxed income. That's a significant amount of tax which is taxed at the individual's normal rate.
The law was set to expire on December 31, 2012, but Congress extended its term to December 31, 2013. Congress failed to pass another extension. This means that short sales, deeds in lieu, and consent foreclosures may now have significant tax implications for underwater homeowners. If you are considering any of these loss mitigation options, then you should consult with an accountant to determine how to best handle the possible tax liability. I am by no means a tax expert, so do not rely on my opinion for tax planning purposes.
It is also possible that loan modifications with a principal reduction feature may lead to tax liability. Again, this is a question for a CPA or the IRS. If I find a definitive answer with regard to loan modifications, I will update the blog with another post.