Debt forgiveness can be taxing

It is IRS policy to tax forgiven debt you are personally responsible for as if it is income. For example, if a credit card company settled a $10,000 debt for 50 cents on the dollar, that would leave a debt forgiveness of $5,000, which the IRS would count as income, just like wages. The same policy held true for most mortgage debt until 2007, when Congress passed the Mortgage Forgiveness Debt Act. That ended the liability for many homeowners -- but not all. In general, if a home is lost to foreclosure or short sale, where you sell your home for less than you owe, the IRS won't add insult to injury by counting the difference as income. There are four major exceptions to the rule: - A cash-out refinance and splurge is taxable. Many homeowners took cash out when they refinanced their homes and used the cash to pay for new cars, boats or vacations. The IRS' reasoning is that only the money spent on home improvement actually adds to a home's value. And that, presumably, diminished the difference between what was owed on the mortgage and the value of the home when it was foreclosed.
- A home-equity line of credit. During the boom years, many homeowners tapped soaring home equity to make all sorts of consumer purchases. But the same rules that apply to refinancing also apply to home-equity loans: The IRS will only forgive the tax liability if the loan money was spent improving your home.
- A vacation home or investment property. If it was not used as a primary residence for at least two of the previous five years.
- A multi-million-dollar home. Only the first $2 million in forgiven debt will be voided under the relief act; all the overage is taxable as income. However, according to Kent Anderson, a Eugene, Oregon based attorney and tax expert, "if the taxpayer was insolvent at the time of the foreclosure, the forgiven debt can be excluded for tax purposes," he said. "It can also be discharged in a bankruptcy and approved by court order."
If, however, you are insolvent (your total liabilities exceed your assets) the above exemptions may not apply at all, but check with your CPA on this issue as well.
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Martin Crawford