In his weekly syndicated column, Kenneth Harney pulled back the curtain on a nasty piece of IRS tax code that can penalize homeowners with foreclosures and short sales.
Because the IRS treats canceled debt as ordinary income, homeowners that "work something out" with their lender may inadvertently add tens of thousands of dollars to their annual tax liability.
According to the tax code, when a creditor agrees to cancel a personal debt of $600 or more, it is required to submit a 1099-C, Cancellation of Debt form to the IRS. And, when the IRS receives this form, it treats the canceled debt as income.
So, if your mortgage lender agrees to "forgive" $40,000 on your mortgage in a short sale, you are required to report that $40,000 as income to the IRS -- even though you never physically held the $40,000.
This is how a person's tax liability can dramatically increase. Imagine if you were taxed on $40,000 that you never "earned".
Capitol Hill is taking steps to offer relief to homeowners by modifying the tax code related to cancellation of debt.
The Mortgage Cancellation Tax Relief Act of 2007 would amend the tax code to forgive debt cancellations on primary residences and is currently before the House Ways and Means Committee, the primary tax legislation body of Congress.