It’s bad enough to lose a house, to walk away, or to have to short sell it. What’s even worse is finding out that you might be responsible for income tax on the forgiven debt. However, in many cases, an income tax disaster doesn’t have to follow the loss of a property.

The whole reason many people short sell their properties or allow them to go into foreclosure or abandon them is that there’s too much debt associated with that property, causing payments which can’t be kept up, or causing the owner to be making payments on a property which is substantially "under water". The act of a short sale or abandonment or foreclosure allows the property owner to get out from underneath the excessive debt associated with the property. In effect some portion, sometimes a large portion, of the debt associated with the property gets canceled or forgiven. However, income tax law presumes that canceled or forgiven debt represents income, and that income is taxable.

As an example, let’s say you own a house worth about $350,000 in today’s market, but you have $500,000 in debt outstanding against that property. You work out a deal with the lender to sell the property for $350,000, which the lender will take in full settlement of all of your debts. In effect, the agreement is that $150,000 of debt goes away. That $150,000 is considered canceled or forgiven debt, and the lender should send you a 1099 reporting that income both to you and the IRS. So, after losing your house you now have to pay income tax on the $150,000 of canceled debt, too? Not so fast.

There are several exceptions to the general rule that the income from the canceled debt is taxable. One is bankruptcy. If the debt was canceled as a result or part of a bankruptcy proceeding, it’s not taxable.

Another exception is insolvency. If the debtor was insolvent (defined as having more liabilities than one’s assets are worth) on the day the debt was canceled, then the canceled debt is non-taxable to the degree the taxpayer was insolvent that day. Using the example above, if the taxpayer’s assets were worth $650,000 on the day of debt cancellation and that taxpayer’s liabilities totaled $750,000, the taxpayer was insolvent by $100,000. In that case, the first $100,000 of debt cancellation income would not be taxable, but the final $50,000 would be subject to tax. However, if that same taxpayer had been insolvent by $200,000 that day (assets of $650,000 and liabilities of $850,000), then none of the debt cancellation income would be taxable.

These first two exceptions to the general rule about the taxability of cancellation of debt income have been around for years. In response to recent events in the worlds of lending and real estate, Congress has also created two more exceptions: the exclusion for debt cancelled on a principal residence, and the exception for canceled debt regarding real estate used in business. These last two are not a straightforward as they might seem (or should be), so some explanation will be required.

The first thing you need to know is the difference between recourse and non-recourse debt. Generally, a debt is a recourse debt if the lender can legally hold you personally responsible for any unpaid amounts. Believe it or not, most mortgages are recourse debts. However, in the majority of cases, lenders are choosing not to go after debtors who had to short-sell or lost their properties, figuring that the debtor is probably already broke and that they’re not going to have much luck trying to squeeze blood out of a turnip.

There are also non-recourse debts. In California where we practice, purchase money debts used to acquire a principal residence are non-recourse by action of law. In other words, California state law effectively prevents a lender from going after a debtor who defaults on a loan which was used to acquire his/her home. This only applies to the original loan, and does not apply if the loan has been refinanced. Many other states have similar rules, but not necessarily all. Generally, when you get the 1099 showing the cancellation of debt income, a box on the form will be checked by your lender showing if they think you could be held personally responsible for repayment of the debt.

It’s important to know the difference between recourse and non-recourse debts, because they’re handled very differently for tax purposes. A default on a non-recourse debt generally does not result in any cancellation of debt income; we simply figure that the property was "sold" for whatever debt remained at the time of default and treat the whole deal as a sales transaction. A default on a recourse debt usually results in the property being treated as being sold for whatever it was actually worth that day, and any forgiven debt above the actual value of the property treated as cancellation of debt income.

The next important thing to know is the concept of "acquisition debt". Acquisition debt is defined for tax purposes as that debt which was used to acquire or improve the property in question, up to certain limits. So if you borrowed $300,000 to buy your home and later refinanced it to take out another $100,000 which was spent on living expenses, only $300,000 of your $400,000 total debt is considered acquisition debt. On the other hand, if you had spent $50,000 of the re-fi proceeds on adding a room to your home, your acquisition debt would be $350,000 ($300,000 purchase money plus $50,000 improvements).

So, what are these new exceptions to the general rule regarding the taxability of cancellation of debt income? The first exception applies to cancelled debt on one’s personal residence. This exception is in effect through the end of 2012. It relates to a short sale, foreclosure or abandonment of your principal residence (where you actually lived), and applies only to acquisition debt related to that residence, and only up to $2 million of acquisition debt. Unfortunately, California law has lower limits for this exception, which can result in taxable income for California in a situation where Federal law allows for complete exclusion of income.

The second exception applies to real property used in business. Without going into a long explanation of tax law, suffice it to say that any rental property or real property used in a business will, in most circumstances, qualify for this exclusion. This exclusion also applies only to acquisition debt, and has a couple of other hard-to-explain limitations. In any case, even with limitations and qualifications, it’s good to have another exception to the general rule about the taxability of canceled debt income which goes beyond the mortgage on one’s residence.

A note of caution: if you do use one of these exceptions, you may be required to reduce any pending tax benefits to which you might be entitled. You might have to reduce passive loss or net operating loss carryovers; you might have to reduce your basis (cost for tax purposes) in some other property; or you might have to reduce some tax credits to which you’re entitled, such as the foreign tax credit, minimum tax credit or general business tax credit.

Another note of caution: lenders seem to have a hard time getting their 1099s right as regards cancellation of debt income. They might fail to issue a 1099, or might issue it late, or might issue it with incorrect data (we’ve seen all of these). Even if no 1099 is issued, it’s your obligation to report the cancellation of debt income, and it’s your problem if the IRS finds out about it later. It’s risky to assume that no 1099 will ever be issued, since some lenders are just backlogged on their paperwork. On the other hand, if the lender provides a 1099 with incorrect data, you have the right to correct it on your tax return.

One of the saving graces about all these exceptions and their attendant limitations, and a great benefit to taxpayers, is that they can be "stacked". In other words, you might have cancellation of debt income which exceeds the limitations of one of these exceptions, but in many cases, another exception can be used to cover much (if not all) of the remaining income. It might be more work and more figuring, but it beats having to write a huge check.

Having given you all this data, it would be irresponsible of us to allow you to assume that’s all there is to know about this subject. As with any tax law, there’s lots of exceptions, qualifications and "gotchas" which can change everything. Also, much depends on the facts of a particular situation, and your facts may lead to a very different outcome from another taxpayer whose facts seemed similar at first glance.

In any case, the moral of the story is that, while losing a home or property can be a difficult experience, in many cases having to pay income tax on the forgiven debt is not a forgone conclusion and can be avoided if you know what you’re doing.