If you borrowed money to purchase your residence from a commercial lender and the lender later cancels or forgives the debt through a loan modification, short sale, foreclosure, etc., then you may have to include the amount of the canceled debt in your income.
Is The Debt That Was Canceled Always Taxable?
No. There are exceptions that are analyzed below.
Qualified Personal Residence Indebtedness
This exception was created by the Mortgage Debt Relief Act of 2007 and will apply to most homeowners. This act allows you to exclude qualified personal residence debt forgiveness up to $2,000,000 on a joint return. This would include debt forgiven in a foreclosure, short sale, deed in lieu of foreclosure, or loan modification. Qualified debt is debt that was used to buy, build, or substantially improve your personal residence, or to refinance debt used for those purposes.
Debts that you discharge through a bankruptcy are not considered taxable income.
If you are Insolvent when your debt is forgiven some, or all of it may not be considered taxable income. You are insolvent when your debt exceeds the fair market value of your assets.
Forgiveness of a non-recourse loan does not result in cancellation of debt income. You will need to consult your tax adviser to determine whether there are any other tax consequences. A non-recourse loan is a loan that you are not personally liable for in the event of a default.
Disclaimer and Circular 230 Disclosure
Disclaimer - This presentation does not constitute legal, accounting or other professional advice. Only through a personal, confidential consultation with qualified legal counsel can anyone properly evaluate their own unique estate planning challenges and determine what, if any, appropriate legal strategies and tactics should be implemented to meet those challenges.
Circular 230 Disclosure - "Nothing in this presentation is intended or written to be used, and cannot be used by any person for the purpose of avoiding tax penalties regarding any transactions or matters addressed herein. You should always seek advice from independent tax advisors regarding the same."