Debts discharged in Bankruptcy are not taxable events.

With the housing market in turmoil, many are looking to a short sale as a way out from under a house that is rapidly declining in value. A true short sale or deed in lieu of foreclosure involves a forgiveness of debt. The borrower either sells or simply hands the property back to the lender and in exchange the lender agrees to cancel the remaining amount due under the note. Generally speaking, when debt is cancelled or forgiven the lender is usually required to issue a 1099 C reporting the amount of the forgiven debt to the IRS and the borrower. When a debt is forgiven, the amount you received as loan proceeds is reportable as income because you no longer have an obligation to repay the lender. For example, you borrow $100,000 and default after repaying only $20,000. If the lender is unable to collect the remaining debt from you or decides to stop trying, there is a cancellation of debt of $80,000, which is added to the amount of income you pay taxes on. If you had been paying taxes based on a salary of $50,000, get ready to pay taxes as if you have earned $130,000 in that year!

The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers the right to exclude debt forgiven as a result of a foreclosure on their primary residence. As a result, in today’s declining housing market, the 1099 C issue arises most frequently in the context of investment properties. Borrowers holding a portfolio of underwater investment properties will see their tax bill skyrocket in the event they successfully negotiate a short sale, deed in lieu of foreclosure or forgiveness of deficiency judgment after foreclosure. Any cancelled debt will result in the dreaded 1099 C and a tax bracket that will likely have no bearing on the borrower’s actual income.

There are exceptions to the forgiveness of debt rule. Bankruptcy can be an attractive option for over-extended real Estate investors because debts discharged in bankruptcy are not taxable events . When a consumer elects to file a bankruptcy case they have the option of shedding their secured debts (such as mortgages and car loans) by surrendering the collateral that served as security for the loan (car or home) back to the lender. Under normal circumstances, surrendering a car or home back to a lender would result in the lender selling the property and holding you liable for the difference between the sale price and what you owed on the loan. If the difference is forgiven, the IRS will send a much bigger tax bill. However, when property is given back to a lender in the bankruptcy context, no remaining debt will be owed and no tax liability for the amounts discharged will result. The tax advantages of bankruptcy extend to almost any type of forgiven debt. Those lucky enough to negotiate a debt settlement with their credit card company will receive a higher tax bill whereas credit card debt discharged in bankruptcy is not taxable.