It is IRS policy to tax forgiven debt you are personally responsible for as if it is income. Say, for example, your credit card company settled a $10,000 debt for 50 cents on the dollar. You'd have a debt forgiveness of $5,000, which the IRS would count just like your wages.
The same policy held true for most mortgage debt until 2007, when Congress passed the Mortgage Forgiveness Debt Relief Act. That ended the liability for many homeowners -- but not all.
In general, if you lose your home to foreclosure or short sale, where you sell your home for less than you owe, the IRS won't add insult to injury by counting the difference as income, at least until 2012, when the act expires.
There are four major exceptions to the rule:
1. You did a cash-out refinance and splurged.
Many homeowners took cash out when they refinanced their homes and used the extra dough to pay for new cars, boats, vacations or other spending.
Say you did that and then got into trouble, losing the house through a foreclosure or short sale. Even if your lender waived the remaining debt, the IRS will treat as income the portion of the forgiven debt that you took out as cash and spent.
Only the funds used to actually improve your home won't be taxed (plus the costs of refinancing the loan). Even if you spent the money on paying off your student loans or credit cards.
The IRS' reasoning is that only the money spent on home improvement actually added to your home's value. And that, presumably, diminished the difference between what you owed on your mortgage and the value of your home when it was foreclosed.
Beware: Some lenders made refinancing offers contingent on homeowners paying off credit card debt. If you took one of those deals, the refinance money will be reported to the IRS and you will owe taxes on it.
2. You have a home-equity line of credit.
The same rules that apply to refinancings also apply to home-equity loans: The IRS will only forgive the tax liability if the loan money was spent on home improvements. Be prepared to show receipts to prove it.
3. You lost your vacation home or investment property.
The market tanked and you lost your vacation home. Unfortunately, if you didn't use it as your primary residence for at least two of the previous five years, you're going to pay the tax.During the housing boom, buying homes for investment purposes soared, accounting for 28% of all sales during 2005, according to the National Association of Realtors. (Vacation homes made up 12%.) And many of these purchases were made with little down payment.The median price for investment properties fell nearly in half to $94,000 by 2010, according to NAR. For vacation homes, the median price paid dropped 26% to $150,000.
4. You owned a multi-million-dollar home.
Houses: What a million dollars buys, only the first $2 million in forgiven debt will be voided under the relief act; all the overage is taxable as income.
Other ways out - If the taxpayer was insolvent at the time of the foreclosure, the forgiven debt can be excluded for tax purposes. It can also be discharged in a bankruptcy and approved by court order.
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