When you escape a debt the IRS normally counts the amount of the debt you were forgiven as income, and taxes you accordingly. In terms of a taxable event, this could be significant to you financially if you short sale your home.
Example: Mr. & Mrs. Jones owe $550,000 on their mortgage, but the current market value for the house is $350,000. Faced with a transfer, they have to sell their home. Their lender allows them to Short Sale their home for the current market value even though it will net less than the balance owed on the mortgage. In agreeing to sale short, the lender also agrees to forgive the debt on the outstanding balance; in this case, $200,000. Enter the IRS, who view the $200,000 as taxable income!
The Mortgage Forgiveness Debt Relief Act addresses this very scenario, and has been in effect for the last since 2007 when the market began its collapse, throwing many homeowners into financial distress by owing more on their mortgage than what their house was actually worth in the changed market. (It has recently been extended to the end of 2013.)
This act allows a home owner a tax exclusion for the forgiven mortgage debt. Without this Act, in the scenario above, the Jones would get a tax bill on the $200,000 as though it were regular, earned income. That means a bill of somewhere around 30%, or $60,000. Quite a deep hole to fall into!
The Mortgage Forgiveness Debt Relief Act is about making it possible to get out from under financial hardship so you can get back on your feet again.
Note: While this is fantastic news, there are some qualifiers to this tax act. Be sure to consult a qualified tax preparer before moving ahead. Also, another thing to consider; the state of California is expected to follow suit with their own forgiveness of debt relief. However, as of this writing, they have not yet extended this tax break on the state level. Plain English: You may get off the hook at the Federal level, but the state is not there….yet.