If you lose your home to foreclosure, deed-in-lieu of foreclosure or short sale, you will likely have something called cancellation of debt income. This is also known as COD income. COD income is taxable.
But, thank goodness, Congress acted with something called the Mortgage Forgiveness Debt Relief Act. This act says that if you have COD income from your home and it was due to original indebtedness or was a refi where the proceeds were used for capital improvements, then you don’t pay tax. Under the current law, though, if you did a refinance and pulled out cash for other purposes, then you will pay tax on the COD income.
The Mortgage Forgiveness law expires on 12/31/12. That means that unless Congress acts to extend this law, if you have a foreclosure on your home, a deed-in-lieu-of foreclosure or short sale, you will pay tax on that COD income.
Remember that you need to also check the state law where your home is. For example, California has a similar COD income exclusion, (limited to debt of $800,000) but California’s law is also expiring 12/31/12.
So, how do you plan for this? Well, of course, it would be helpful if we knew what Congress would do. But, since we don’t, if you have any choice at all, try to get the home deal finalized in 2012. At least that way you know what the law will be.
We hope that Congress will extend the law. But, of course, these days nothing is too certain when it comes to logical action out of Washington.