To Forgive is Divine but…it may also be taxable!

As many of you know the real estate crash caused many homeowners to owe more than the home was worth (“upside down”). There were many foreclosures and short sales and many banks would “forgive” the indebtedness deficiency of the homeowner.

For example, you owned a house which, in the good times, was worth $250,000 and your mortgage is $225,000. After the real estate crash your home is now only worth $175,000 but you still owe $225,000. You are now upside down $50,000.

Even if you sell your house at $175,000 and pay the bank all of the proceeds directly to the bank you still owe the bank $50,000!. What happens if the bank “forgives” that debt just to get rid of the property and adjust to the current market place? Under Section 61(12) of the Internal Revenue Code gross income includes discharge of indebtedness income. Exceptions are provided under Section 108 of the Internal Revenue Code but many homeowners may not qualify for the exceptions.

In recent years Congress has made an exception for “qualified principal residence indebtedness which is discharged before January 1, 2014”. Basically that means that the $50,000 would not have been included in your gross income and you would not have to pay taxes on such income. IMPORTANT: This provision has NOT YET been extended beyond January 1, 2014.

Advice: If you are working on a short sale or some other arrangement in which your indebtedness on your home is forgiven you MUST keep this in mind because your debt may be forgiven but you may be hit with a tax bill in April of 2015 that you had not anticipated!. There may be other exceptions for which you could qualify but discuss with your tax adviser BEFORE you make the deal.


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