Debt Forgiveness and Its Impact on YouIf you sold your Hendersonville home via a short sale, you are probably aware of the term “debt forgiveness”.  This is when a lender “forgives” a portion of what you owe on your home so you can sell it for less.  While the lender may “forgive” this debt, Uncle Sam does not.  In terms of taxes, any amount you would have owed but the bank decided not to collect on may be considered taxable income.  Since taxes are due soon (this year’s deadline is Tuesday, April 17, 2012), I thought it would be important to discuss debt forgiveness and its impact on you, the taxpayer.

As I said before, in general, forgiven debt is considered taxable income by the government.  In essence, you were given a certain amount of money when you signed your loan to begin with.  So, when the bank decides to forgive a portion of the debt, it is like they gave you a credit.  This is considered income and must, therefore, be taxed.  However, until the end of this year (December 31, 2012), a homeowner doesn’t have to pay taxes on the forgiven mortgage debt as long as the debt was from a principal residence and the amount forgiven didn’t exceed the original loan amount plus improvements.

This law also applies to foreclosures as well as a loan modification that includes a reduction in your Hendersonville home’s principal balance. The loan modification provision only applies if you are currently using the home in question as your permanent residence.  The non-taxable mortgage debt relief also only applies to the original loan amount.  It does not typically apply to second mortgages or home equity lines of credit that are not used for improvements on your home.

When a portion of a mortgage debt is forgiven, the bank will send out a 1099 to both the Hendersonville homeowner and the IRS that shows the amount forgiven.  You must then file a Form 982 to explain what the debt was forgiven for and why you shouldn’t have to pay taxes on it.  Whatever is taxable should then be filed on your 1040.  Talk to your tax adviser/preparer about this.  They should be able to answer any questions you have.

Rich Cooke, your Western North Carolina real estate specialist

Originally posted on my Hendersonville real estate blog here: