Short Sale/Foreclosure Tax Info By a CPA (Accountant)

The Mortgage Debt Relief Act of 2007 allows taxpayers to exclude income from the discharge of debt on their principal residence through 2012. This includes debt reduced through mortgage restructuring and foreclosure, but only applies to debt used to buy, build or substantially improve your principal residence. Refinanced debt is only forgiven up to the amount that would have qualified before refinancing and the loss sustained on the short sale or foreclosure of your principal residence is not deductible.
Discharge of debt on rental property is not excluded from income. If a financial entity cancels or forgives debt of $600 or more, you will receive a Form 1099-C, Cancellation of Debt. Unless you meet one of the exceptions, this canceled debt is ordinary income and must be reported on your tax return. Exceptions include bankruptcy or insolvency. Insolvency occurs when the total of all your liabilities is more than the fair market value of all of your assets immediately before the cancellation of debt. If the cancellation of debt exceeds the amount by which you were insolvent, the difference must be reported as income.
If discharge of debt is excluded under the bankruptcy or insolvency exceptions, you must reduce your basis in the rental property by the amount of excluded cancellation of debt income. The lender's foreclosure or repossession of the rental property is treated as a sale or disposition and may result in realization of a gain or loss for income tax purposes. The gain or loss on the disposition of the property is measured by the difference between the fair market value of the property at the time of the disposition and your adjusted basis in the property. Your adjusted basis in the property is your cost plus improvements, less depreciation and less the amount of excluded cancellation of debt income.
Real estate and taxes go hand and hand. If your personal real estate is in a foreclosure please consult an accountant or tax professional. Taking a short sale offer on an investment property could have substantial tax consequences. Many clients are choosing to walk away from the property vs accept the short sale for tax reasons. Your home is another issue and the two should not be treated the same. Accounting rules are moving more in the direction of helping homeowners get out of this financial crisis by giving tax leeway to homeowners in poor financial conditions.