Is mortgage debt that is discharged taxable as ordinary income?
This topic is a real bugaboo that seems to be attracting quite a bit of attention these days, what with foreclosures, short sales, bankruptcies and walk-aways in full bloom in the garden known as the mortgage meltdown. Unfortunately, there seems to be more misinformation and urban myth floating around than good professional advice. If you have any reservations at all about your status, don't make any assumptions about this subject without consulting a lawyer or accountant.
The short answer is that Congress did pass the Mortgage Forgiveness Debt Relief Act of 2007, which does provide a lot of relief, and will probably benefit most of the folks that are most in need of the relief it provides. But if you have investment property or a HELOC, keep reading.
First of all, the general rule is that forgiven debt gives rise to "ordinary income" which is a taxable event ordinarily reported on IRS Form 1099. Historically, there has been an exception that if the taxpayer is insolvent (which means only that their debts exceed their assets) then the forgiven debt is not taxable to the extent of the insolvency. This means simply that if I owe $100 but my assets are only $80, then I am "insolvent" to the measurable tune of $20, and the amount of the forgiven debt that is not taxable would be limited to that $20. The filing of a bankruptcy petition gives rise to a "presumption of insolvency" which usually is the end of the issue and the taxpayer won't be taxed on the forgiven debt. Absent a bankruptcy petition, you would normally have to prove the insolvency to the IRS in order to avoid the tax.
