If you are forgiven of mortgage debt through a modication or short sale of your promary home, you most likely are not liable for taxes on the forgiven amount. The specific criteria to have forgiven debt excluded are the debt must have been incurred to buy, build or substantially improve the residence, called “acquisition debt, and the property must be the taxpayer’s primary residence.
The exclusion applies only to acquisition debt up to $2
million, or $1 million for married taxpayers filing separately, and
cancelled mortgage debt not used to buy, build, or improve a principal
residence is not eligible for the exclusion, but may be excludable under
a different provision, such as bankruptcy or insolvency.
Under the Mortgage Debt Relief Act of 2007, the provision is for
debt forgiven between 2007 and 2012, unless the bill gets extended.
For those considering a short sale, waiting to do a short sale after December 31, 2012 may lead
to tax penalties that could have been avoided for the homeowner unless
the bill gets extended.