Free Debt or is it Debt Free?

I was watching a TV news program the other evening where a reporter was interviewing a man in California about the home mortgage crisis. The man explained to the reporter that the home he and his wife had purchased about three years ago for $800,000, was now only worth about $375,000. As a result they had decided to simply walk away from the home and stop making loan payments even though they could afford to continue to pay the monthly installments. I wondered why the reporter never mentioned anything about a potential tax liability related to debt forgiveness. I was remembering back several years ago when one of my clients faced a debt forgiveness issue with a totally different outcome. The client was struggling to make a go of it in a retail business. When the client finally gave up and closed the business, the suppliers were kind enough to forgive the debts they were owed for inventory purchased and sold by my client. Needless to say you can imagine how shocked my client was when I told them that they owed some $25,000 in income taxes. Their response was a predictable, how can we owe income taxes when we have no assets, no cash and our business is a total loss? I explained to them that if you owe a debt to someone else and they cancel or forgive that debt, the canceled amount is usually considered taxable income and you will have to pay income taxes on the dollar amount of the debt forgiven.

So why wasn’t the reporter mentioning this possibility to the California couple? Well, the answer is the Mortgage Forgiveness Debt Relief Act of 2007. This act generally allows taxpayer to exclude income from the discharge of debt on their principal residence so long as the debt is secured by the home. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. Bankruptcy and insolvency of the taxpayer also qualify for the exclusion.

The provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

So why did my client owe taxes on their forgiven debt? The reason is that their debt was business debt and not personal debt related to their principal residence. For more information about cancelled debts see the IRS Publication 4681 and IRS news release IR-2008-17.

So what do you think about debt forgiveness? Should taxpayers like the couple in California be allowed to simply walk away from their mortgage? If they walk away from their mortgage, won’t you and I ultimately end up paying for it through our taxes?