The good news is that the Mortgage Forgiveness Debt Relief Act of 2007 allows borrowers who received a debt cancellation to avoid paying federal taxes on the amount. The law was introduced to help struggling home owners to get out of their underwater mortgages during the recession. The bad news is it is limited to the primary home not a second home or an investment property, debt was used to buy or improve the home, forgiven loan amount shall not be over $2 million ($1 million for married filing separately) and the forgiven amount must be agreed before the end of 2013. The law expired at the end of 2013 and any forgiven loan amounts after that date will be considered as ordinary income and will be subject to federal tax.
How do you calculate the amount? Let’s say you borrowed $180,000 to buy a $200,000 home, and you sold the home on a short sale for $100,000. The lender forgives the $80,000 you owed the lender and that amount will not be considered as income for tax purposes for year 2013. Any subsequent years it will be considered ordinary income and will be subject to federal income tax.