[Note: this column was originally published in November 2012, but due to the Band-Aid approach to tax law favored by Congress, it is relevant once more]
If you are one of the 97% of the population whose home is worth significantly less than when you purchased it (relax real estate brokers of America, I’m exaggerating for effect), you’ve likely been seeking out some type of debt modification with your lender. Or perhaps things have gotten so bad that you’re contemplating a foreclosure or short sale.
Here’s the thing: anytime a mortgage is modified (i.e., reduced), the borrower is required to recognize cancellation of indebtedness (COD) income under Section 61(a)(12) to the extent of the debt forgiveness. Similarly, if a property is sold at foreclosure or in a short sale and the underlying mortgage is recourse (meaning the borrower has personal responsibility for any excess loan deficiency remaining after the sale), then to the extent the remaining deficiency is forgiven, the borrower will again recognize COD income.