Wow, this paragraph is truly an eye-opener
It is not clear to me, the DDI is excluded in the year your report when you are insolvent, but then can it be an item hanging out there that you eventually have to pay when you become solvent again? (sort of in the analagy of the capital gain/loss offsetting rule) From the explanation it seems the DDI exclusion only apply as long as you remain insolvent.
So the walk-away borrowers could still face a steep tax bill once they work themselves out of the hole (despite the hole is dug partly by themselves when they stretched themselves too thin.)
<<Debt Discharge Income Basics
The general rule is that DDI is a taxable income item. For the year that DDI occurs, the lender should report the amount to you (and to the IRS) on Form 1099-C (Cancellation of Debt). As stated, you generally must report the DDI as income on your return for that year. However, there are some exceptions to the general rule that DDI is taxable. If the borrower is insolvent (which means your debts exceed the value of your assets), the DDI is entirely excluded from taxation as long as the borrower is still insolvent after the DDI occurs. If the DDI causes you to become solvent, part of the DDI will be taxable (to the extent it causes solvency). The rest will be excluded from taxation. To the extent DDI consists of unpaid mortgage interest that was added to the loan principal and then forgiven, the forgiven interest that you could have deducted (had you paid it) is excluded from taxation.
If the DDI is from seller-financed debt (i.e., mortgage debt owed to the previous owner of the property), it is excluded from taxation. However, your basis in the property must be reduced by the excluded DDI amount. If you then sell the property for a gain, the gain will be that much bigger. As explained earlier, however, you can probably exclude the gain under the home sale gain exclusion rules.
Taxable Gains and DDI Can Also Arise in Foreclosure
So far, we've only covered short sales where you sell your home to a third party. But what happens tax-wise if the mortgage lender forecloses? Here is the general rule. Say your property is foreclosed (or transferred to the lender via a deed in lieu of foreclosure). When the mortgage debt exceeds the property's fair market value (FMV), the transaction is treated as a sale for a price equal to FMV. Naturally, the sale will trigger a tax gain if the FMV exceeds your tax basis in the home. Once again, however, you can probably exclude the gain under the home sale gain exclusion rules.
If the lender then forgives all or part of the difference between the higher amount of the mortgage debt and the lower FMV of the home, the forgiven amount is DDI, and it's taxable unless one of the exceptions explained earlier applies.>>
AI
