Caveats of mortgage debt forgiveness

REThink Real Estate

By Inman News Feed
Add Comment Add Comment | Comments: 1 | Posted Jan. 14, 2010

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REThink Real Estate

Tara-Nicholle Nelson
Inman News

Q: I heard from my agent that if you did a short sale in 2009 even if you have pulled cash out during the life of your loan, a law was passed that you will be exempt from the IRS taxing you. Has this law already been passed or in the process of being passed? For what years does this apply? I'm thinking of doing a short sale and need to know the ramifications. Thank you for your help!

A: First things first: I'm not a certified public accountant (CPA). I'm a real estate broker and a lawyer, but generally speaking, I'm not in attorney mode unless I'm sending out bills for $350/hour.

Mindset Management

While I believe in do-it-yourself education as much as the next gal, it sounds to me like you're at the point where you need to talk with a CPA, enrolled agent (EA) or other tax maven with real estate knowledge to get a professional opinion on your personal situation.

Asking real estate agents for tax advice is a setup for your failure and theirs. I know funds are tight, but you should be able to find a reputable tax preparer who is familiar with the Mortgage Debt Forgiveness Relief Act of 2007 and can answer your questions now in anticipation of them filing your post-short-sale return. Also, the IRS Web site offers some surprisingly straightforward resources on this topic, straight from the source.

This is not the decision to make on your own.


Many people are just now learning that when you owe someone money and that person forgives the debt, the money they lent you might become taxable income. This is coming to the public's awareness now as people are having debt forgiven by their mortgage servicers via short sales and (very rarely) loan modifications, or more commonly by their credit-card banks through settlements. In fact, this was a major deterrent to homeowners wanting to do a short sale vs. a walkaway at the beginning of the housing crisis.

Since this income is taxable as regular income, homeowners in my area who were contemplating short sales at prices $200,000 below their loan amounts were forced into tax-free foreclosure to avoid incurring new $60,000 tax bills they couldn't afford. To avoid this absurd result, the Bush administration enacted The Mortgage Debt Forgiveness Relief Act in 2007, which technically allows taxpayers to exclude "income" from the forgiveness of debt secured by their personal residences.

This law is already in full effect, and applies to exclude up to $2 million of principal residential debt forgiveness via short sales and loan modifications completed in calendar years 2007 through 2012.

But here's the rub. The Mortgage Debt Forgiveness Act of 2007 excludes only income from the forgiveness of debt used "to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes," to quote the IRS. It does not exclude income from the forgiveness of debt secured by your home that you used to go on vacation, pay off credit cards, buy a car, or pay for medical bills or tuition. It also does not exclude income from debt forgiven on your vacation home or investment property.

However, if you are inclined to try a short sale, you might be able to get out of paying taxes on the debt forgiven on several other grounds. If you are insolvent (i.e., your total debts are greater than the fair market value of your total assets), debt forgiveness is not taxed. Neither is debt discharged through bankruptcy or indebtedness on a nonrecourse mortgage (a loan where your lender's only recourse against your default is to foreclose on the property).

Action Plan

Before you list your home for sale, consult with a CPA and also with a bankruptcy attorney. Ask them to review your entire situation, and work with these professionals and your real estate agent to carve out an action plan you'll be satisfied with in the long run.

Tara-Nicholle Nelson is author of "The Savvy Woman's Homebuying Handbook" and "Trillion Dollar Women: Use Your Power to Make Buying and Remodeling Decisions." Ask her a real estate question online or visit her Web site,


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1. Anonymous said... on Sep 7, 2010 at 11:52AM

“Judging by your answers here I doubt you are worth $350 to people whom would require your services in these circumstances.

Even in foreclosure, servicers can persue a deficiency which if forgiven would be taxable.

Also, refinanced debt IS included. The very next line after your quote from the bill states, "It would also include refinancing of this debt, to the extent that the refinancing does not exceed the amount of refinanced indebtedness."



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