When a creditor cancels or “forgives” a debt, it is deciding not to collect that debt. It does this for various reasons, none of which are for the purpose of helping you.
When the debt is forgiven following a settlement negotiation, a short sale, or a foreclosure, the creditor must report the amount of the cancelled debt to the IRS on a form 1099-c.
Under Section 108 of the Internal Revenue Code, the IRS than treats that cancelled amount as income.
If, for example, you earn $75,000.00 per year and a home sold at short sale for $100,000.00 less than the lender was owed, the IRS will treat you as having earned $175,000.00 in income.
1. The debt was discharged in bankruptcy
If the obligation on the debt was included in and than discharged in a bankruptcy proceeding, it isn't attributable to you as income. If you received a bankruptcy discharge on the obligation, and a 1099c document from the lender, you will need to file a form 982 with the tax return. This form tells the IRS how the forgiven debt is being treated and why it is not being included in the income disclosure on the return.
2. If the cancelled debt occurred while you were insolvent
If you were “insolvent” you can reduce the amount of the cancelled debt from your income. See U.S.C. Section 108(a)(1)(B). Unlike bankruptcy, a determination of your asset value for insolvency purposes includes all of your assets, including retirement funds like IRA and 401k funds. In Bankruptcy, these assets are generally out of reach.
3. If you qualify under the Mortgage Forgiveness Debt Relief Act of 2007
President Bush signed this act into law and it is in place through the end of this year 2012. In essence it protects those who have cancelled debt related to a principal residence. It doesn't apply to second mortgages used to buy a boat or pay off debt, nor does it apply to second homes.
Losing a home, whether as a result of forced sale, short sale or foreclosure is traumatic. I speak with many people who have made the experience more traumatic than necessary by ignoring the consequences of the 1099c. If a debt is going to be forgiven and it is relatively large, you will need to determine whether an insolvency or the 2007 act will apply to reduce or eliminate taxation on the amount. If not, bankruptcy as an option should be reviewed before the debt is forgiven if possible.