Q: I short sale my home 2009. I received a 1099C from my mortgage company.
In box 2 it reflected a five digit amount. Correct me if I am wrong, but under the Federal Forgiveness Act which is due to expire in 2012, states that I do not have to report the interest as depicted in box 2 of the 1099C. Am I correct?
A: You have to report the income, but you may be eligible to claim the exemption under the Debt Forgiveness Act if the home secured by the forgiven debt was your principal residence. For more info see http://www.irs.gov/pub/irs-pdf/p4681.pdf & http://www.irs.gov/irs/article/0,,id=179073,00.html
See also http://www.ftb.ca.gov/aboutftb/newsroom/mortgage_debt_relief_law.shtml for debt forgiveness for California taxes.
Reporting the forgiven debt as income and having to pay taxes on it are 2 different things. You report the forgiven/canceled debt on IRS form 982 and attach it to your tax return. Please also note that not all forgiven debt can be excluded from the taxable income. The Debt Forgivesness Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. A forgiven refinanced loan qualifies for the exemption only to the extent that the principal balance of the old mortgage before the refinancing would have qualified. In other words, if you refinanced and cashed out you may not be able to exclude the entire forgiven debt. The same is true for any home equity lines of credit to the extent that the proceeds from the HELOC were not used to make improvements to the home. If you used the HELOC to pay debts or buy other things or go on trips, the forgiven HELOC is taxable income unless you can claim another exemption such as insolvency. I would recommend you consult with a tax attorney or CPA before you file or amend your 2009 taxes.
You will also want to discuss capital gains taxes with the tax expert as mere fact that you short sold does not automatically rule out that you realized a gain for purposes of capital gains tax determination as the capital gains is determined by the difference between the adjusted basis on your home and the net proceeds from the sale. While most home owners don't have to worry about capital gains taxes these days because they bought their homes for more than they are worth now, there are people who repeatedly refinanced and pulled money out of their home and the reason why they had to short sell was not because the home's value dropped below what they purchased it, but because they overmortgaged.
In summary, yes you have to report the canceled debt that was reported on the 1099C and depending on your circumstances you may be able to exclude all or a portion of the canceled debt from your taxable income.
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