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Debt Forgiveness: Watch Out for the Tax Consequences
In light of the current economic crises plaguing our country, many of us may have clients whose homes are on the brink of foreclosure, or are being sold by way of a short sale. The client may also have staggering credit card debt. Therefore, when drafting a property settlement agreement that involves debt forgiveness (i.e., foreclosure, short sale, reduction in credit card debt), it is critical that matrimonial attorneys be aware of the tax consequences because the financial impact on a client can be enormous.
Background
Historically, if debt were forgiven or cancelled by a commercial lender, it had to be included as income on one's federal and state tax return, and was taxable. For example, if the total amount of the mortgage debt immediately prior to foreclosure was $220,000, and the fair market value of the property was $200,000, the amount of the debt forgiven, $20,000, was treated as taxable income ' unless of course the borrower qualified for an exception under the Federal Tax Code, i.e., bankruptcy, insolvency, certain farm debt, and non-recourse loans.
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