Have you ever wondered what happens when someone has debt forgiven or cancelled? This could be loans, credit cards, mortgages, etc. Is that taxable income on your tax return? It could be!
The most common debt forgiveness we see right now is on home mortgages. For example, if you had a foreclosure or short sale, you would most likely have had some portion of the debt you owed on the property forgiven. If you are one of the unfortunate home owners who purchased when the market was high and got yourself into a bind, you are not alone. This happened to so many people that the government actually intervened. The Mortgage Forgiveness Debt Relief act was enacted in 2007. Normally the debt that was forgiven would have to be included on your tax return as income. That could end up being a hefty liability!
The good news is that from 2007-2013, if you had qualified principle residence indebtedness debt cancellation, it most likely did not have to be included on the tax return for the IRS.
The bad news is, this is not necessarily true for your state. North Carolina, for example, adds back that cancellation of debt and taxes you on it for 2013. If you recall hearing, the IRS extended this act for 2013, whereas, North Carolina did not follow suit.
If you find yourself in a situation where you must foreclose or short sale your home, be sure that you know how this will affect you from a tax standpoint. Both IRS and most states will be reverting back to counting the cancelled debt as income in 2014 and moving forward. There are some other possible ways that the debt could be excluded, such as if you were insolvent. It is important to consult your tax advisor so that you can properly prepare. While knowing that you have to take it in as income may not change the situation, you could plan accordingly.