Taxable Income From Debt Cancellation Not An Issue For Many "Underwater" Homeowners Where Lender Refuses To Cancel Unpaid Loan Balance On Short Sales

Many people owing more on their mortgages than what their homes are worth are often concerned about the income tax they may have to pay in a short sale if their mortgage lender agrees to accept less than what is owed in order to agree to such a sale.

However, before a homeowner starts wondering how much income tax may have to be paid on such a transaction, he/she must first find out if the lender will actually agree to cancel the unpaid balance in the first place (ie. no debt cancellation = no income tax). Regrettably, many short sellers are entering this type of deal simply assuming that the bank, in accepting less than what's owed, is letting them off the hook for the unpaid balance of the loan.

For the story of one unpleasant "eleventh hour" surprise for a short-seller (ie. it wasn't until after a prospective buyer was found that a real estate agent for a homeowner learned that his client was to be left on the hook for about $170K ), see San Francisco Business Times: Sellers owe balances after short sales.

See also:

• The Wall Street Journal: A Short Sale May Not Mean You're Home Free,
• North County Times: Lawyers say lenders set stage to collect on 'short sales' (Foreclosure may be better option for some struggling homeowners),
• Puget Sound Business Journal: BofA wording may cause more foreclosures,
• The New York Times: The Pain of Selling a Home for Less Than the Loan.

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For those "lucky" underwater/upside down short-sellers able to squeeze a "debt cancellation concession" from their lenders and be let off the hook for the unpaid balance, the following information from the Internal Revenue Service may come in handy in determining how much income tax may be owed to the Feds, and more importantly, whether a homeowner can qualify for one of the law's exceptions from taxation (ie. exception for taxpayers for acquisition or home improvement debt forgiven on their principal residence if the balance of their loan was $2 million or less, insolvency exception, & bankruptcy exception are the three most common) that will allow him/her to dodge the tax either entirely, or at least partially:

• IRS Publication 4681: Canceled Debts, Foreclosures, Reposessions and Abandonments,
• IRS Information Release IR-2008-17: Mortgage Workouts, Now Tax-Free for Many Homeowners; Claim Relief on Newly-Revised IRS Form,
• The Mortgage Forgiveness Debt Relief Act and Debt Cancellation,
• IRS Form 982: The amount of debt forgiven must be reported on this form and must be attached to your tax return.