In 2007, Congress enacted the Mortgage Forgiveness Debt Relief Act in 2007 — legislation that exempted from personal income taxes the portion of mortgage-related debts that were forgiven by lenders in the aftermath of the financial crisis.
Under the Internal Revenue Code, when the repayment of some or all of a loan obligation is waived — such as in the case of a mortgage cancellation, short sale or some other type of modification that reduces the unpaid balance of a loan — the IRS views the forgone amount the same as if it were paid as ordinary income, and it is fully taxable to the recipient. Congress saw fit to shield borrowers against the financial perversion that would ensue when debts are forgiven with one hand and taxed with the other. The resulting legislation was originally intended to remain in place through 2012. It was later extended through 2013.
As of Jan. 1, 2014, borrowers are required to pay taxes on the forgiven values of their mortgage-related debts, just as banks have begun to write them off. The difference, of course, is that consumers are on the “paying” side of the equation while lenders are on the “receiving” end. That’s because of the tax deduction that may be claimed when the write-off is for previously recognized (and taxed) profits and/or diminished loan balances.
The only remaining way for distressed homeowners to avoid this dilemma is to file for protection under Chapter 7 of the Bankruptcy Code either prior to, or in lieu of, doing a short sale. If a bankruptcy petition is filed BEFORE the forgiveness of a debt, Section 108 of the Internal Revenue Code takes effect. Under Section 108, there is absolutely no tax consequence to any debt discharged, in whole or in part, in bankruptcy proceedings. Speak to an experienced bankruptcy attorney before considering a short sale.