Income from the cancellation of debt is a problem for many taxpayers because the volume of defaulted debt continues to increase. The current economic downturn was triggered by an unprecedented number of defaulted subprime home mortgages. Home prices have fallen nationwide for the first time since the 1930’s.

The applicable Internal Revenue Code section provides that gross income includes income from whatever source it is derived, including income from forgiveness of debt. Certain cancellation of debt income, however , is excluded from taxation such as, among other things,:
1. discharge of debt under the federal bankruptcy laws;
2. discharge of debt when the taxpayer is insolvent;
3. discharge of debt that is qualified farm indebtedness.

Who benefits from a so-called short sale on real estate? The lender whose debt is being partially satisfied, the municipality whose property taxes are being paid, and the realtor whose commission is being paid.

What’s the benefit for the homeowner/debtor who receives nothing from the sale?

That’s a rhetorical question. In fact, often, the homeowner/debtor who is talked into this short sale believes he is “doing the right thing.” In reality, the homeowner may be creating nondischargeable tax liability due to the “phantom” income he is receiving by virtue of the sale; income on which he is taxed on.The difference between what he owes on the real estate mortgage loan(s) and the amount the lender(s) are actually being paid from the short sale is taxable income under applicable tax law.

We as lawyers, who concentrate our practice in debtor/creditor law, bankruptcy, insolvency and business reorganization rarely advise a client to enter into a short sale arrangement. Why should a debtor, who already can not pay his bills, assist in such a transaction only to receive a mandated 1099 statement evidencing income on which he will be taxed? There are better solutions including allowing the lender to foreclose its mortgage and the debtor exercising his rights under the federal bankruptcy laws.

Feel free to call our office to obtain more information on cancellation of debt and how, in the long run, it may hurt you, not help you.