Are You Liable for the Loan?
State law will determine whether or not you are actually liable for your home loan in the first place. California, for example, is a "non-recourse" state. Here original, un-refinanced purchase money is a loan taken out by the property and you are not liable for it at all. However, in many states, you will be liable for all or a portion of your home loan. This is called a "recourse loan." Recourse loans are tax free when you receive the money, which means they are taxable when forgiven unless there is an exception! You should speak to your tax advisor regarding your specific loan(s) and whether you may exclude "Cancellation of Debt" (COD) income from your return!
Principal Residence Exclusion
Originally, this exclusion was set to expire December 31, 2012. However, it has been extended as part of the Fiscal Cliff deal until December 31, 2013 and is an excellent way to avoid taxes on mortgage forgiveness. In order for your mortgage to qualify for this exclusion, it must be "acquisition indebtedness" which typically means, original purchase money, refinanced purchase money, and money used to substantially improve the property. It must also be secured by the principal residence. As a result, certain common circumstances do not qualify such as taking a line of credit on another piece of property to purchase your residence. Similarly, loans secured by your residence to finance college, a wedding, or other personal expenses do not qualify. Be prepared to discuss with your tax preparer all the financial transaction related to your home from purchase to present and what those funds were used for.
You Aren't Out of the Woods Yet!
Once you have qualified for the Principal Residence Exclusion, you are required to reduce the "basis" of your property by the same amount. Typically, basis means what you paid, but it may be increased or decreased by certain factors. This amount will be used to determine whether you have to pay taxes on the capital gains from the sale of your home (capital gains taxes are increased in 2013). At this stage, you may exclude up to $500,000 in gain from income for a married couple if certain qualifications are met. In general, using the home as your primary personal residence for 2 out of the last 5 years will qualify you to exclude this gain. However, if you or your spouse have used the "Section 121" gain exclusion recently, your exclusion now may be limited or disallowed.
What if I Don't Qualify?
Maybe you took a loan against your home to finance some major personal expenses. Maybe you just bought the home a year ago and lost your job. Maybe the home used to be a rental, but now you have converted it to your residence. All of these situations will add little wrinkles into the calculations involved with the Principal Residence Exclusion. Other common methods to exclude COD income from your taxes include the Insolvency and Title 11 Bankruptcy exclusions. Depending on your particular situation, one of these options may be more suitable to your needs. Regardless of the circumstances, though, you should meet with someone knowledgeable about this area BEFORE beginning the short sale or foreclosure process. By doing so, you can strategize more effectively. But remember, both processes take a LONG time! Get started as soon as possible to ensure that you meet the December 31, 2013 deadline!