Can disabled veteran get a cancellation-of-debt tax break on short sale of his home?

2 min read

Dear Tax Talk,
In Nov. 2007, I was enlisted in the Army and received PCS military orders to relocate to Germany. We were not able to lease or sell our home from January 2008 to the present day, nor could we afford to pay the mortgage while living overseas. Two months ago we received a short sale offer of $78,000 for the property. The principle balance is $88,000 and interest accumulated every month to every year. I didn’t use my VA loan benefits. It was an adjustable arm rate conventional loan. The total amount today, including interest, is $96,350.

We had purchased the property in 2003 and moved in 2008. We returned to the States in April 2014. We tried three different companies to buy, sell the property. Finally, my sister’s dear friend told us she’s willing to give it a shot for a short sale. It’s her first attempt at a short sale and she hung in there and grinded it out. The lender’s short sale department informed us if approved we’ll receive a Form 1099-C, Cancellation of Debt. It is currently under review. I’m a retired disabled veteran and need advice to see if I qualify for a tax exemption.

Thank you for your assistance.

Respectfully submitted,
— Eric


Dear Eric,
The Mortgage Forgiveness Debt Relief Act was extended through 2016 and it has a special provision for “cancellation of qualified principal residence indebtedness” which allows you to exclude the forgiven debt as income. That means you wouldn’t owe tax on this forgiven debt. Unfortunately, the law has not been extended to 2017 and beyond.

In general, cancellation of debt is includible as income unless you meet one of the exceptions for excluding it as income. IRS Form 1099-C, Cancellation of Debt, is issued by creditors when they forgive or discharge indebtedness, so the IRS will be looking for it on your tax return. The exceptions are:

  1. Discharge of indebtedness in a title 11 case (a type of bankruptcy).
  2. Discharge of indebtedness to the extent insolvent (not in a title 11 case).
  3. Discharge of qualified farm indebtedness.
  4. Discharge of qualified real property business indebtedness.
  5. Discharge of qualified principal residence indebtedness.

According to the IRS, qualified principal residence indebtedness is any mortgage you took out to buy, build or substantially improve your main home. It does not include using the money from your home for any other purpose such as travel, paying off credit card debt, education, etc. If this is no longer your main home or your short sale did not occur until after 2016, don’t give up yet as help may still be available to you: You may qualify for the insolvency exclusion listed in No. 2 above.

You are insolvent to the extent your debt exceeds all of your assets. This sounds simple. However, be sure to check out IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments, as it has a very detailed worksheet to help you calculate “insolvency” along with further details on all of the exclusions available to taxpayers.

You will need to complete IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attach it to your tax return.

Thank you for your service to our country and I wish you and your family all of the best in 2017.

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