Tax provisions regarding debt foregiveness on a short sale or foreclosure

I was recently asked by a real estate professional if I knew the tax implication of a homeowner having mortgage debt forgiven via a short sale or foreclosure.   At the time I did not but have since researched the issue and thought I would blog about it.  Keep in mind that I AM NOT a tax professional and if the topic in this post pertains to you then I recommend you seek individual help from a qualified tax professional.

In general, this topic is covered in section 108 of the Internal Revenue Tax Code.  Mortgage debt forgiven via a short sale or foreclosure can be excluded from taxable income so long as it meets a set of rules.  CLICK HERE to read a print off directly from the 2011 CCH US Master Tax Guide about these rules.  The mortgage debt must have been qualifying acquisition indebtedness (any “cash-out” will be included in taxable income) and it must have been secured against the tax filers primary residence.  This provision is set to expire in 2012.

Also, in section 108 of the IRC it states that debt discharged as a part of a court approved Chapter 11 bankruptcy and/ or debt discharged when the taxpayer is insolvent outside of bankruptcy is also excluded from taxable income.  I’m sure I am missing a lot of details so feel free to comment below if there are any important provisions I neglected to mention.

From this we can deduct that if a mortgage was used to acquire rental property or was used to pay-off consumer debt then any discharge of this debt will be included in a taxpayers gross income for tax filing purposes unless they are insolvent.