Understanding ‘Cancellation of Debt’ Taxes

August 18th, 2011, by

Q: I was watching TV and saw an expert tell a lady in financial trouble to sell her house before 2013 or she would have to pay a large tax. What tax was the person talking about?

A: The expert was probably advising the woman to do a short sale, sooner rather than later. A short sale is when your lender allows you to sell your home for less than you owe. Many people who can no longer afford their mortgage or who can’t get a loan modification turn to a short sale.

If you owe a debt to someone else and they cancel or forgive that debt, such as what might happen in a short sale, the canceled amount may be taxable. By law, any company that writes off $600 or more worth of your debt has to send you—and the IRS—a form 1099-C, Cancellation of Debt. You may have to include the cancelled amount in income for tax purposes.

This is how the IRS explains the tax as it relates to forgiven debt. When you borrowed the money, you were not required to include the loan as income because you had to pay it back. However, if the loan is forgiven, the amount you received as a loan is viewed as income because you no longer have an obligation to repay the lender.

Because of the housing crisis, Congress passed the Mortgage Forgiveness Debt Relief Act of 2007, allowing people to exclude up to $2 million of forgiven debt on your principal residence. The limit is $1 million for singles or a married person filing a separate return. The forgiven debt won’t be taxable for tax years 2007 through 2012. The Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence or to refinance debt incurred for those purposes.

So, if you think you can’t hold on to your house, and you may need to do a short sale, you have until next year to get this exclusion. The amount of debt forgiven must be reported on IRS form 982, and this form must be attached to your tax return.

Last modified: August 18, 2011 at 2:14 pm