Potential Tax implications when losing your home to foreclosure or short sale
When a property is sold as a short sale or lost to foreclosure, it is treated as a sale or exchange from which you may realize a gain or loss. The amount of debt that is forgiven is seen as a gain since this is an amount you will no longer have to pay in the future. Except in cases of a gift or bequest, you must include cancelled amount of debt which you are personally liable for as income. However, all or a portion of this canceled debt may be excluded as income under the following exclusion classes:
Qualified Principal Residence Indebtedness
You can exclude cancelled debt from income if the mortgage was taken out to buy, build, or substantially improve your primary home. The maximum amount you can treat as qualified principal residence indebtedness is $2 million is married filing jointly, or $1 million if married filing separately or single.
Title 11 Bankruptcy
Debt cancelled in a title 11 bankruptcy case is not included in your income if the debtor is under the jurisdiction of the court, and the cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court.
An individual is insolvent if they had total liabilities in excess of the FMV of all assets immediately before the cancellation. In this instance, you would only need to include up to the extent you were insolvent as part of your income.
Total debt/liabilities – $200,000
Less FMV Assets – $195,000
Extent of Insolvency – $5,000
In this example, the maximum portion of cancelled debt that would need to be recorded as income would be $5,000. Even if the amount being forgiven is greater than this amount.
Qualified Real Property Business Indebtedness
You can exclude cancelled income as qualified real property business indebtedness if it was incurred or assumed in connection with real property used in a trade or business. The debt also must be secured by that real property.
The amount you can exclude from income is limited to the excess (if any) of:
The outstanding principle amount of the qualified real property business debt divided by the FMV of the business real property securing the debt, reduced by the outstanding principal amount of any other qualified real property business debt secured by that property.
In addition, the amount of cancelled debt cannot be more than the total adjusted bases of depreciable real property you held immediately before the cancellation of the qualified real property indebtedness.
Cancellation of debt can be excluded from income in regards to investment property when the borrower is filing for bankruptcy, or is proving insolvency.
Legal disclaimer: I am not an attorney or tax professional. The information contained in this article/blog is intended to provide general information on the subject and not to provide any legal or tax advice. You should not act upon this or any information without first seeking independent tax and/or legal counsel.