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Tax Pro Advice: A Home Short Sale: How Debt Cancellation Affects Your Taxes

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The following is a guest post from H&R Block’s Leigh Mutert, CPA and Community Manager, the second in a series of articles is running to provide our readers with tax tips. H&R Block is also offering free tax return codes, worth up to $55 to interested readers. The first two posters to leave a comment on this article will receive a code for H&R Block’s premium tax return software.

For homeowners considering a short sale of their home, take note. A short sale or foreclosure can directly impact your tax bill. Normally, debt forgiveness results in taxable income, but the Mortgage Forgiveness Debt Relief Act of 2007 makes homeowners exempt from taxes on the forgiven loss on sale of home.

A Short Sale Explained

A short sale on a house occurs when the homeowner sells the home for less than the amount owed on the mortgage and the bank or financial institution forgives the rest of the debt. Typically, the lender agrees to accept the sales proceeds for release of the mortgage lien on the home even though the sales price is less than the total outstanding mortgage. This allows the homeowner an opportunity to sell the home to avoid foreclosure. The debt forgiven is reported as income. You will receive a Form 1099-C from your lender.

Under the Mortgage Forgiveness Debt Relief Act, you may be able to exclude debt forgiven when filing your taxes.

Mortgage Forgiveness Debt Relief Act of 2007 extended through 2012

Normally, debt forgiveness results in taxable income, but under the Mortgage Forgiveness Debt Relief Act of 2007, taxpayers may exclude debt forgiven on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

What is cancellation of debt?

If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the canceled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender.

However, you may be able to exclude part or all of this income if the debt was qualified principal residence indebtedness, you were insolvent immediately before the discharge, or if the debt was canceled in a title 11 bankruptcy case. If you have questions about your situation, you can get a free 30-minute consultation with a tax pro at an H&R Block office near you.

If only a portion of the loan discharged is qualified indebtedness, the exclusion applies only to the amount of debt discharged that exceeds the amount of the loan that exceeds the non-qualified indebtedness.

For example, assume that a taxpayer has a $500,000 loan outstanding on his principal residence, of which $80,000 is equity debt. If $100,000 of the loan amount is discharged, only $20,000 ($100,000 discharged debt — $80,000 equity debt) of the debt discharge qualifies for the exclusion under the new provision.

Ten facts about mortgage debt forgiveness

1. Normally, debt forgiveness results in taxable income. However, under the Mortgage Forgiveness Debt Relief Act of 2007, you may be able to exclude up to $2 million of debt forgiven on your principal residence.

2. The limit is $1 million for a married person filing a separate return.

3. You may exclude debt reduced through mortgage restructuring, as well as mortgage debt forgiven in a foreclosure.

4. To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence.

5. Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion.

6. Proceeds of refinanced debt used for other purposes – for example, to pay off credit card debt – do not qualify for the exclusion.

7. If you qualify, claim the special exclusion by filling out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attach it to your federal income tax return for the tax year in which the qualified debt was forgiven.

8. Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the tax relief provision. In some cases, however, other tax relief provisions – such as insolvency – may be applicable. IRS Form 982 provides more details about these provisions.

9. If your debt is reduced or eliminated you normally will receive a year-end statement, Form 1099-C, Cancellation of Debt, from your lender. By law, this form must show the amount of debt forgiven and the fair market value of any property foreclosed.

As you begin to plan for tax filing, take note that if H&R Block prepares your return, or if you filed using H&R Block tax preparation software guarantees 100% accuracy and maximum refund guarantees, plus free audit support with guidance, and representation in the event of an audit.

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This week, had articles about balance transfer credit cards featured in the Carnival Of Wealth and the Carnival of Credit Score and Debt.

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About the author

Jeff Weber

Jeffrey Weber has been following and blogging about the credit card industry since 2004. He has also written for Forbes and been cited in a wide range of major media outlets including USA Today, Time, MSN Money, The Christian Science Monitor, The Detroit Free Press and numerous other prestigious online and print publications.

Jeffrey resides in Easton, Connecticut and enjoys spending his free time chasing after his two year old son, watching films with his wife and occasionally taking a holiday to go snorkeling.

– has written 279 posts.

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