The Good, the Bad, and the Unknown

Calculating the income tax consequences of debt forgiveness can be complicated; however, certain scenarios generally have a better outcome than others. For example, a loan modification on a primary residence with only the original mortgage, usually comes out okay. The same goes for a short sale or trustee’s sale on a primary residence where debt is canceled on mortgages where the loan proceeds were either used to purchase or improve the residence. Properties which were rentals for the entire period of ownership often times will not have adverse tax consequences as a result of distressed property transfers, as well.

What types of properties, after a distressed property transaction, have a greater likelihood of negative tax consequences? 1) Primary residences that have been refinanced with cash out, the proceeds of which were expended for things other than home improvements; 2) Primary residences where a second mortgage was taken, and the proceeds were not used for home improvements; 3) Homes converted to rentals after losing much of their value; 4) Vacation homes that have been refinanced with cash out; and 5) Investments in raw land.

There are many other examples of typically good and bad scenarios; and it certainly is possible that the debtor can escape negative tax consequences in the above hypotheticals. But alternate tax law provisions may need to be employed to find exclusions to the debt forgiveness when the general rules don’t help.