Tax Implications of Debt Forgiveness

Debt forgiveness occurs when your bankruptcy case is closed, upon foreclosure, or short sale of a primary residence.
If your home is underwater and is given up in foreclosure or sold as a “short-sale,” the IRS will issue a 1099-C and come after you for the deficiency because debt you no longer have to pay back is considered an income to you. The reasoning behind the regulation stems from the idea that you borrowed money with the intention of paying it back and when you don’t, then you have pocketed some money that is considered as income rather than a debt. Same with the short-sale – because in essence, you are forgiven the debt amount.

Prior to 2007, many distressed debtors in foreclosure or short-sale were beset by such harsh consequences. There may be a recourse due to the passage of “The Mortgage Forgiveness Debt Relief Act of 2007.” This Act, which is due to expire on 12/31/2012, allows a debtor up to $2,000,000 in forgiven-debt not to be declared as income. Boston, Massachusetts, does not have a counterpart to this Act and therefore taxes will be owed to the state.

The qualifications requires that you be “insolvent” at the time of debt forgiveness. This means that your assets have to be worth less than your debts.