Is Forgiven Debt Taxable?

QUESTION:  (Brett)  On a short sale, (where a bank is not fully paid) is the forgiven debt taxable income?

ANSWER:  (John)  Technically yes, but most people get an exception and do not have to pay tax on the forgiven debt.   I forwarded this question to my accountant for a more complete and accurate answer.  

John,

 Generally, if a taxpayer owes a debt that is canceled or forgiven, the canceled amount is taxable income.  There are exceptions:

Bankruptcy – Canceled debt is not included in gross income if the debt is canceled in a bankruptcy case under the U.S. Bankruptcy Code.  The debtor must be under the jurisdiction of the court, and the cancelation of debt must be granted by the court or occur as a result of a plan approved by the court.

Insolvency – Canceled debt is excluded from gross income up to the amount by which the taxpayer’s liabilities exceed the fair market value of assets.  This determination is made immediately before the cancelation of debt.

A foreclosure or a short sale results in canceled or forgiven debt.  These are treated as a sale or exchange of property.  If this is a primary residence, then the normal rules for exempting the income from taxation come into play.

The bankruptcy and insolvency exceptions apply to income resulting from foreclosure or sale of property.

Have any of your clients contact me regarding their personal situation. I’d be happy to help.

Gary