Tax Consequences of Foreclosure or Short Sales

Existing tax law provides that discharged debt, whether after a foreclosure or short sale, is generally taxable income realized in the year the debt was forgiven, unless an exception applies. Generally only reductions in principal and not forgiveness of interest results in discharge of indebtedness income ("DOI"). Usually a lender is required to issue a Form 1099-C to report the DOI to the IRS. Taxpayers are required to disclose DOI to the IRS whether the lender issues a 1099-C or not. Taxpayers may be able to exclude the DOI from income if an exceptions to DOI applies.

Exceptions 

Expired Statute 

In December, 2007, Congress passed the "Mortgage Forgiveness Debt Relief Act of 2007" to alleviate tax consequence for some homeowners in foreclosure. This Act excluded from taxable gross income certain cancelled discharged debt that may otherwise arise with respect to a "qualified principal residence indebtedness."

This act was scheduled to expire on December 31, 2012, but was subsequently extended for another year.  The act expired on December 31, 2013 and has not yet been extended by Congress.

Remaining Exceptions

Two existing exceptions to DOI are the insolvency and bankruptcy exceptions. 26 U.S.C. section 108(d). If the borrower is insolvent, DOI is not taxable. If the debt is discharged in bankruptcy, DOI is also not taxable. Another exception is the "purchase price infirmity doctrine". This allows DOI to be excluded from income where the lender agrees to write down the purchase money debt to the true value of the collateral as the purchase price was inflated in the original transaction due to fraud or misrepresentation. Another exception from DOI is when the liability was contested. Pursuant to Zarin v. Comm'r, 916 F.2d 110 (3d Cir.1990), DOI is not income where there is a legitimate basis for the borrower to claim that the debt was never owed or collectible because illegal.