Early last year we learned that the IRS had decided not to impose income tax on homeowners who sold their houses via a short sale.

This is a sale in which the buyer pays less than the current balance due on the house and the mortgage company “forgives” the remaining balance. In order to qualify for a short sale, homeowners must show proof that their home did not or would not sell for an amount equal to or greater than the balance due on the mortgage. Additionally, they must submit proof that they do not have enough assets to make up the shortfall.

Until recently, homeowners were required to pay income tax on the forgiven balance because the IRS treated it as income. That policy was reversed under the Mortgage Debt Relief Forgiveness Act of 2007, and applies to the sale of qualified principal residences after 2006 and before 2010.

The decision was, assumedly, in response to falling home values across the country. While short sales used to be a once-in-a-while occurrence in any given market, they are now very common. In fact some Realtors are specializing in handling nothing but short sales.

Removal of the tax imposition lifted a huge burden for homeowners who were already in financial trouble.

Now we’re warned that consumers who were unable to pay their other debts in 2008 may face income tax on the amounts that were forgiven or cancelled. The tax liability may also extend to the forgiven interest and penalties as well as the forgiven principal.

As was formerly the case with forgiven mortgage debt, the IRS treats these amounts as income.

If the amount exceeds $600, the creditor is required to report the amount to the IRS and the taxpayer on a form 1099-C. This does not apply to debts wiped out in bankruptcy.

The loophole in this tax law is insolvency. If you receive a 1099-C, contact a tax professional or the IRS for instructions on how to demonstrate that insolvency. This may remove your obligation to pay tax on the forgiven balances.

If you are currently negotiating to settle a debt, or if you may do so in 2009, get tax advice before you settle. Then you can be prepared with the proper paperwork to show insolvency and avoid this tax.

This entry was posted on Sunday, February 8th, 2009 at 5:32 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.