Forgiveness of debt on recourse mortgages is a significant issue for taxpayers going through a foreclosure or entering into a short sale. For those who are unaware, there can be challenging tax consequences.

One of the most important issues that must be resolved is determining if the mortgage was a recourse instrument or non-recourse instrument. Recourse mortgages are instruments that allow the financial institutions to hold the borrower personally liable for the debt. With a recourse mortgage, once a foreclosure has occurred and the financial institution has agreed to forgive any remaining deficiency balance, the taxpayer must address the tax impact of the debt forgiveness.

Non-recourse mortgage debt occurs when the only security for the loan is the home itself and the lender is not able to pursue the borrow for any deficiency. In this case, there is no debt forgiveness and the only issue the homeowner needs to be concerned with is calculating the gain or loss on the disposition of the property.  Debt cancellation can be an issue for non-recourse mortgages though on a short sale.

If your debt is recourse it does not automatically mean that you have a tax liability. Debt forgiveness is normally a taxable event. However, in many situations a taxpayer may find relief under one of the many exclusions. The exclusion that will help most homeowners is the Mortgage Forgiveness Debt Relief Act, which was enacted in 2007. In some circumstances, qualified principal residence indebtedness can be excluded from taxable income.

Make sure that you carefully analyze all your tax documents and determine the proper treatment of any debt forgiveness. Completing the tax forms can be challenging. Just make sure that you get them right the first time.

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