Discharge of debt is generally considered income for tax purposes – and it will be again in 2014 for principal residence indebtedness.
Many taxpayers took advantage of not being taxed on discharge of debt for principal residences from Jan. 1, 2007, through Dec. 31, 2013. Unfortunately, this exclusion has ended effective for the 2014 tax year. It applied to homeowner’s mortgages or equity loans secured by their residence.
For those who had their home reposed by the bank or had a short sale in which the fairmarket value of the home was less than the balance owed on the mortgage, the bank allowed them to walk away from the mortgage without paying the remaining balance still owed.
And because the IRS had a provision in one of their code sections in which this deficient balance was not considered to be taxable income, the taxpayer did not have a taxable event as a result of this transaction.
Starting in 2014 this loophole is no longer available. If the bank forgives debt related to a mortgage or home improvement loan secured by your primary residence, that debt forgiveness will now be considered taxable income.
The company that discharged the debt will send a 1099 form at tax time, and the taxpayer will be required to include the amount of debt discharged as income the tax return.
The IRS provides for five situations in which this discharge of debt is not taxable income. Those five situations are:
- A debt discharged in a bankruptcy action under Title 11 of the U.S. Code.
- A discharge when the taxpayer is insolvent outside bankruptcy.
- A discharge of qualified farm indebtedness.
- A discharge of qualified real property business indebtedness.
- A discharge of qualified principal residence indebtedness occurring before Jan. 1, 2014.
