Avoiding Income Taxes On Debt Cancellation Not Automatic; Must File Required Form; New Law Applies Only To Loans Used To Buy, Improve Primary Home

In a story from KUSA-TV Channel 9 (Denver, Colorado), IRS National Taxpayer Advocate Nina Olson is reported as giving this reminder on avoiding income taxes on the cancellation of debt when homeowners lose their primary residence to foreclosure, or when the debt cancellation is incident to either a loan modification or a short sale of the their primary residence:

• [T]he amount of debt that is cancelled is actually taxable income under the tax laws, unless there is a rule that it is not taxable. In 2007 Congress passed a law that says if you lost your home to foreclosure and you used the mortgage to buy or improve your home, then the amount of cancelled debt would not be taxable to the extent that you used it to buy or improve your home.(1)

• But you have to tell the IRS that by filling out FORM 982.

For more, see Taxpayer advocate offers tips for homeowners.

Go here for more on Dodging The Income Tax On Real Estate Foreclosure & Short Sales.

(1) What this means is that if a homeowner refinanced a home, took cash out, and blew it on a vacation, a wedding, or used it to pay off car loans, credit card balances, student loans, medical bills or anything else other than making home improvements, then to that extent, the homeowner is out of luck and will owe taxes on the cancelled debt attributable to the amount blown, acording to the new law passed in 2007.

However, even if the debt cancellation does not qualify for favorable tax treatment under the new law, it might nevertheless qualify for similar favorable tax treatment under already existing law (in connection with debt cancellation (a) by reason of filing for bankruptcy, or (b) when the taxpayer was insolvent, or (c) in a number of other circumstances). For more on this point, see IRS Publication 525 (pages 19-20 - "Canceled Debts") and IRS Publication 908 (pages 21-23 - "Debt Cancellation"). If qualified, this favorable tax treatment is available to anyone, is not limited to homeowners, and applies to cancellation of any debt (ie. car loans, credit cards, etc.) short sale income tax