"Income" from the Cancellation of Debt
Generally, if you owe a debt to someone and they cancel or forgive the debt, you are treated for income tax purposes as having income and may have to pay tax on this income. At the moment, there are major exceptions for debt forgiveness and reduction on principal residences. However, these exceptions are due to expire at the end of 2012.
Bankruptcy always offers an alternative way to ensure that debt forgiveness does not result in income being reported by the lender. It adds insult to injury to be taxed on the "forgiveness" of debt resulting from financial hardship.
Tax Consequences of a Short Sale, Foreclosure, or Modification
In April 2010, California passed a law that provides homeowners with an exclusion from income tax obligations when a short sale results in debt forgiveness. The law provides an exclusion from tax for individuals who have received up to $800,000 of forgiven debt. The full $800,000, though, is not excluded. Instead, the state excludes the first $500,000 of all forgiven debt up to $800,000. Individuals who have received debt forgiveness that is greater than $800,000 will not have any relief from tax consequences. They must report all of the forgiven debt as income. The law applies to state income tax for 2009 through 2012.
The Federal government has an even more generous exclusion. The Mortgage Debt Relief Act of 2007 typically lets taxpayers exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. p to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately).
For both California and the Federal government, these laws "sunset" or end at the end of 2012. It is currently unclear whether either program will be extended.
Also note that both of these exclusions (California and Federal) apply only to debt from a principal residence.
Tax Consequences of Debt Discharged in Bankruptcy
Debt cancelled in a Chapter7 or Chapter 13 bankruptcy is excluded from income. You must still file a form to report your cancelled debt. See a tax professional to ensure that you file your taxes properly to benefit from the protection afforded by bankruptcy.
You also do not include a cancelled debt in income to the extent that you were "insolvent" immediately before the cancellation of the debt. Insolvency is defined as a circumstance in which your liabilities excelled the fair market value of assets.
For more information, see the IRS website. This does not constitute tax or legal advice. Please retain qualified bankruptcy counsel and seek the assistance of a tax professional to further explore these topics.