The tax consequences on a LOAN MODIFICATIO, SHORT SALE OR FORECLOSURE,arise from the fact that the IRS considers the amount of the debt that you didn't repay as income to you. For example, if you owe $100,000, and the lender accepts a payoff of $50,000 in a short sale, then the lender has canceled

$50,000 of your debt. The IRS would say that you have $50,000 in income.

(NOTE: If the lender gets a deficiency judgment against you, then they cannot also claim a tax loss for the same amount. They have to choose one or the other.)

If the sale was of your primary residence, then you may be exempt from paying taxes

on the gain thanks to President Bush and the Mortgage Debt Relief Act of 2007. From

the IRS website: "The Mortgage Debt Relief Act of 2007 generally allows taxpayers to

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. This provision applies to debt forgiven in calendar

years 2007 through 2012."

However, if you are not able to exclude the income through the Mortgage Debt Relief

Act (for example if the property was not your principal residence), then you may have

to pay taxes on the gain, even though you did not receive any money. That is why it is

referred to as a "phantom gain".

If your home was worth over $100,000, then the $50,000 income would be

considered "capital gains". If the home was worth less than $50,000, then the income

would be considered "cancellation of debt" income (COD Income). If your home was

worth between $50,000 and $100,000, then part of the income would be considered

capital gains, and part of the income would be considered COD Income. For example,

if the fair market value of the home was $80,000, then you would have $30,000 in

capital gains and $20,000 in COD Income.

The IRS knows about your phantom gain because the lender sends them a form called

a 1099-C, which shows the amount of canceled debt income. On that form, the lender

states what they think the fair market value of the home is. That number is not set in

stone. You can use a different value when filing your taxes. But you need to justify the

value that you select, for example by including comparable sales from the area. Include

a note explaining what you did and why.

In many cases, the lender will fail to send out the 1099-C. In that case, you still have to

report the income, but you have more discretion in determining the fair market value.

Of course you still need to justify the value that you select.

In most cases, it is to your advantage to treat the income as COD Income, because you

can often qualify to get the tax on the COD Income waived. However, if you do not

qualify to get the COD Income waived, then you will probably pay less in taxes if the

income is treated as capital gains (assuming you owned the property for more than

365 days, which makes it "long term" capital gains).

HOW DO I GET CANCELLATION OF DEBT INCOME WAIVED?

If you are not able to exclude the COD income through the Mortgage Debt Relief Act,

then there are 3 primary ways or "exceptions" that allow you to get COD Income

waived.

1 - Insolvency Exception

If you are insolvent, then you do not have to pay taxes on the COD Income.

Insolvency means that your debts are greater than your assets, or in other words, you

have a negative net worth. When using the Insolvency exception, you can only get COD

Income waived "to the extent that your liabilities exceeded the fair market value of

your assets immediately before the cancellation." For example, if you had $50,000 in

COD Income, and your net worth was zero before the COD Income, then you would get

100% of the COD Income waived, but if your net worth was $20,000, then you could

only get $30,000 of the COD Income waived.

To claim insolvency, include IRS Form 982 when filing your taxes.

2 - Qualified Real Property Debt Exception

To qualify for the Qualified Real Property Debt Exception, you have to meet all of the

following:

1. The property must have been used in a trade or business (not a primary

residence or passive "investment"). This is a pretty gray issue, but if you have

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some activity relating to the property then it can probably be considered a trade

or business. It doesn't have to be a real estate trade or business. As a landlord

you can be considered to be in a trade or business if you were actively involved

in the management of the property.

2. The debt must be secured by real property, and the debt has to be recorded

("perfected").

3. You must make the proper election on IRS Form 982 when filing your taxes,

and it must be filed with the original income tax return relating to the COD

Income.

4. You must have used the debt to acquire, construct, or improve the property. If

you refinanced and pulled out money for something besides the property, then

you can't use this exception.

5. The maximum amount you can exclude is equal to the LESSER of either:

1. Your tax basis in the property (So if you've been depreciating the

property for many years, then you might not be able to exclude much of

your COD Income through this exception.)

2. The balance of the debt less the fair market value of the property secured

by the debt. (For example if you owe $100,000, and the fair market value

of the property is $80,000, then you could only exclude $20,000 of COD

Income.)

If this exception gives you a partial reduction in tax liability, you can still use other

exclusions to further reduce your liability.

To claim the Qualified Real Property Debt Exception, include IRS Form 982 when

filing your taxes.

3 - Bankruptcy Exception

If you get debt discharged as part of a Bankruptcy, you do not owe taxes on that debt.

Claw Back

In each of these three exceptions, the IRS wants to be paid back for the amount of the

"discharge of indebtedness" (the amount that you didn't have to pay taxes on). They

call this "claw back". It means that the IRS requires you to look for a way to reduce

your other tax deductions to make up for not paying taxes on the COD Income. Some

examples of "claw back" would be reducing the tax basis on the property, reducing the

tax basis on another property, taking away passive losses, or taking away other losses

on your return. If none of these options are available, then the IRS may not be able to

get any "claw back".

You can see more details in IRS Publication 4681.

Hopefully this helps clear things up somewhat, but obviously the tax consequences of a

short sale, foreclosure, deed in lieu of foreclosure, or even a loan modification are

fairly complex. As always, make sure to consult your tax professional.