One unanticipated consequence of working out any deal with a lender that forgives some of a borrower’s debt is that ordinarily forgiveness of indebtedness (when a creditor writes off a debt) counts as income for tax purposes. For example, if a borrower owes $100,000 on a credit card, and the credit card company settles the debt for $50,000, the $50,000 that the borrower no longer has to pay back is income.
Previously, homeowners who paid less than their original mortgage required could only avoid a significant tax liability if they could show that they were insolvent, which was complicated and sometimes impossible. The Mortgage Forgiveness Debt Relief Act of 2007, however, makes an exception for certain situations involving mortgages. The Act permits borrowers to exclude from income amounts that are forgiven on the borrower’s principal residence. The Act does not apply to investment properties or second homes, and it only applies to residential mortgages. It does not apply to credit cards or car loans. The exclusion is also limited to $2 million ($1 million if married and filing separately).
You may want to consult a tax attorney in a foreclosure situation to find out your liabilities.