An interesting article in the Los Angles Times by Kenneth R. Harney, Passing the test on canceled mortgage debt has tax rewards, has some very important points about the IRS and how they handle income taxes when it comes to canceled mortgage debt when home owners who are underwater sell their home as a short sale. The most important point is what is in quotation marks below.
In its latest guidance, the IRS focuses on several key points that owners — and former owners — need to know. Tops on the list: If a lender wrote off a portion of your mortgage debt, you don’t automatically qualify for special tax treatment. To the contrary, there are essential tests you need to pass to qualify: The debt your lender canceled must have been used by you “to buy, build or substantially improve your principal residence.”
When you receive mortgage relief any money which was not used to purchase or improve the property as approved by the IRS is treated as ordinary income and is taxable. Kenneth goes on to give an example:
The IRS offers a hypothetical example of how borrowers can mess up their chances for tax relief. A taxpayer took out a first mortgage of $800,000 when he bought his home years ago. Thanks to strong appreciation, the house was soon worth $1 million and the owner refinanced the mortgage to $850,000. The loan balance at the time of the refi was down to $740,000, and the owner used the $110,000 in cash-out proceeds to buy a new car and pay off credit card debts.
Bad move. A year or two later — presumably well into the recession and housing bust — the home value had plunged to between $700,000 and $750,000. The owner then persuaded his bank to allow a short sale for $735,000 and to cancel the remaining $115,000 of unpaid debt.
Does the owner get tax relief on the full $115,000 under Congress’ special exemption? No way, according to the IRS. He escapes income taxes on just $5,000 of the $115,000, because he spent the other $110,000 on a car and credit card balances — neither of which counts as “qualified principal residence” debt.
As with any tax advise, I am not an expert and you should consult with your CPA or tax attorney. I would recommend reading Kenneth full article for it is one of the better I have read about this subject. Also remember each state has different rules for state taxes when it comes to mortgage relief and again professional advise is something you should consider.