June 01, 2014

The Phantom of the Foreclosure Crisis: Looming Income Tax Liability

Dustin A. Zacks

This article was originally published under the title “Real Estate Law: The Phantom of the Foreclosure Crisis,” in GPSolo, Vol. 31 No. 6 (2014) as abridged from Probate & Property, Vol. 27 No. 5 (2013). © 2014 by the American Bar Association. Reproduced with permission. All rights reserved.

Many homeowners under threat of foreclosure attempt a short sale or a deed in lieu of foreclosure settlement. Their goal is to escape liability for a potential deficiency between the selling price of the distressed property and the amount owed on the original loan. For federal income tax purposes, such a cancellation of debt (COD) is generally considered ordinary income. Many distressed homeowners face the risk of not only losing their homes but also owing thousands of dollars in income taxes. This article describes contexts in which COD tax liability arises, explains how such liability can be avoided, and analyzes policy implications of such liability.

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