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Is Cancellation of Debt Income?

Generally, any cancellation of debt must be reported to the IRS as income and such may increase a filer’s tax liability.  There are however a number of exceptions and I’ll start off by saying that you should always review your personal situation with a CPA or other tax professional.  You might be asking yourself, what do income taxes have to do with real estate?  We’ll I’ll tell you.  For several years now, those borrowers (your clients) that sell their property via short sale or obtain a loan modification with a principal reduction, oftentimes receive debt cancellation as part of the process.  Until January 1, 2015, those borrowers were exempted in certain circumstances from having to pay income tax on the cancellation of debt.  Recently, Congress just extended the exemption through January 1, 2017.  Here are the details from the 60,000 foot perspective.


If your client borrows money, to say purchase a home, they owe a debt to the bank.  Now when this client sells their house in a short sale, the difference between what the client owes the bank and the proceeds of the sale is known as the deficiency.  As part of a short sale, the bank may waiver or forgive the deficiency.  In other words, the debt is cancelled and the client is relieved of the obligation to repay the bank the deficiency.  Until recently, these borrowers could expect to declare that deficiency as income and may have to pay taxes on the amount forgiven.  As discussed above, Congress extended the exemption through January 1, 2017, however as with anything there are exceptions.


  1. The debt must be “Qualified Principal Residence Indebtedness”


“Qualified principal residence indebtedness is any mortgage you took out to buy, build, or substantially improve your main home. It also must be secured by your main home. Qualified principal residence indebtedness also includes any debt secured by your main home that you used to refinance a mortgage you took out to buy, build, or substantially improve your main home, but only up to the amount of the old mortgage principal just before the refinancing.”

IRS Publication 4681.


Consequently, if you took a home equity loan to take a vacation or buy a boat, such would not qualify as “Qualified Principal Residence Indebtedness.”


  1. The debt must pertain to the client’s “main home”


“Your main home is the one in which you live most of the time. You can have only one main home at any one time.”  IRS Publication 4681.


  1. Different Rules for Retention Programs


Home Affordable Modification Programs (HAMP) and other principal reduction programs are generally not taxable.  However a reduction on the principal balance owed on the home loan may qualify as cancellation of debt and remain taxable.


It is important when assisting your distressed borrower clients in navigating retention and liquidation options, that you advise that they consult with the appropriate tax professional.  Your client’s tax lability may be an important factor in how they choose to proceed in their specific circumstance.

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