Cancellation of debt provides tax relief for homeowner’s short sale

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Dear Tax Talk,
I was told that mortgage forgiveness tax relief for 2015 and 2016 was part of the big tax and spending bill that recently passed Congress. Is this now law, and is it safe for me to accept a short sale contract on my home? Thanks.
— John

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Dear John,
In December, President Obama signed into law a package of “tax extenders” that included the extension of the Mortgage Forgiveness Debt Relief Act. This means that if you meet the IRS requirements, the cancellation of debt will not be included as income to you.

The general rule is that debt forgiveness is includible in taxable income. The Mortgage Forgiveness Debt Relief Act provided special relief to homeowners who had “qualified mortgage interest” forgiven by lenders. However, the provision expired as of December 31, 2014. The law has now been extended through 2016, which is good news to many homeowners.

Prerequisites for tax relief

To qualify for the exclusion there are 2 very important items to note:

  • First, the debt must have been used to buy, build or substantially improve your principal residence. This does not include debt on a 2nd home or investment property. This means if you refinanced your home and used the proceeds for other purposes, such as an automobile purchase, credit card payoff or anything else, that forgiven debt would not be “qualified” and generally would be includible in income.
  • Secondly, the limit on the excludable amount is $2 million ($1 million if your filing status is married filing separate).

If you have had debt forgiven, you should be issued Form 1099-C, Cancellation of Debt, which reports the amount of the debt forgiven and the fair market value of any property that was foreclosed. When you are preparing your Form 1040, you will need to complete Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, to report the amount of debt excluded from your income.

As always, there may be other factors involved in your short sale, so I encourage you to consult a tax adviser to make sure that everything is properly addressed.

Thanks for the great question and all the best to you.

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