In 2007, former President George W. Bush signed the Mortgage Forgiveness Debt Relief Act into law. The act allows for homeowners who would have otherwise been subject to taxes on forgiven mortgage debt following a foreclosure to avoid having to pay them. The tax relief act was extended through the end of 2014, and currently is expected to be renewed again. This is welcomed news for homeowners facing financial difficulties, as the last thing a seller wants to deal with after undergoing a hardship is taxes. Up to $2 million of forgiven debt is excusable, and generally tax payers will be off the hook for taxable income associated with mortgage restructuring and forgiven mortgage debt. Despite the Debt Relief Act of 2007, certain cancelled debt income is taxable.
In the event, that a commercial lender cancels or forgives the debt of an unpaid loan, the borrower may have to include the amount forgiven as income for tax purposes. Lenders are required to report the amount of cancelled debt to the Federal Government on a 1099-C, Cancelation of Debt Form. When the money was originally borrowed it was not required to be included as income because of the borrower’s obligation to repay the lender, when the obligation is forgiven, the money becomes taxable because it is now essentially free income.
A simple way of looking at this is if a borrower takes on a loan of $12,000 and then subsequently defaults on the loan after only paying back $4,000, the lender is unable to collect what’s left in the debt and cancels the remaining debt of $8,000. This money is taxable income.
Non-Taxable Debt Income
There are four prominent exceptions to canceled debt income being taxable:
- Bankruptcy: Money owed that is dismissed through a bankruptcy filing is not taxable income
- Insolvency: If a borrower is unable to pay the balance of a debt because the amount of total debt is greater than the fair market value of all personal assets the cancelled debt is non-taxable
- Specific Farm Debts: If the debt is a direct result of the operation of a farm, and greater than 50 percent of the borrowers income from the previous 36 months came from farming, the canceled debt is not taxable
- Non-Recourse Loans: Loans that are non-recourse only allow the lender in the event of a default to repossess the financed property. Meaning a lender cannot pursue the borrower personally in a default. Cancelled debt associated with non-recourse loans is not taxable.
Taxable Income on a Short Sale
One of the most commonly asked questions we hear is “will I have to pay income taxes on a short sale?” The answer to this question is largely dependent on the mortgage type. Although there is no singular answer, the odds are in your favor that you will not have to pay income taxes on the cancelled debt associated with short sale.
Because all government backed mortgages are non-recourse loans, FHA, VA and USDA loan borrowers are entirely exempt from paying income taxes on cancelled debt.
For borrowers of traditional loans, a possibility does exist of income taxes on cancelled debt after a short sale. If the deficiency is forgiven a CPA can help minimize the borrower’s tax-liability. Under the Mortgage Forgiveness Debt Relief Act of 2007, cancelled debt on a short sale will not be taxable if the forgiven debt was used to buy, build or improve a primary residence or to refinance a debt for those purposes.
For all questions regarding a short sale contact VA Home Loan Centers at 888-573-4496 to speak with a representative. Remember, VA HLC provides our services free of charge to veterans needing to short sale their home.