Question: When we bought our home, my wife’s parents lent us $50,000 to pay off miscellaneous credit card and other family debt so we could get a “fresh start” in our new home. I signed a demand note prepared by her father’s attorney, but my wife didn’t.

I never thought much about it until my wife and I got divorced, and then the note came up as being part of marital debt. During our negotiations, my former in-laws forgave the debt and returned the note to me. I got the house – and all of the debt consisting of both a first mortgage and a maxed-out line of equity. Because of the economy, the house we bought for $265,000 is now worth only $210,000. At the same time, because we refinanced in the good times, the first mortgage and home equity debt I agreed to pay total more than $300,000.

I am working on a “short sale” of the house by which the holder of the first mortgage will agree to take the house back at $210,000, and the home equity lender will take a loss. I thought this was a good deal until I heard that the selling short would result in me paying taxes. How can this be?

Answer: Under the circumstances you describe, you will probably face income taxation on the forgiveness of the $50,000 loan, but not on the short sale of the house. Here’s why:

Generally, in situations where a debt is forgiven, reduced, or paid off by another person, the amount you no longer owe is taxable income in the year the debt is forgiven. When a loan if forgiven as a voluntary gift between relatives, there may not be income tax, but the person who forgives the debt may be required to pay a gift tax. In your situation, we believe you would be hard-pressed to claim a gift from your in-laws in an acrimonious divorce case. Therefore, we believe you must report the $50,000 forgiveness of indebtedness.

At the same time, you are joining the millions of Americans who took advantage of the “quick credit” fix and now owe more to your mortgage lenders than your home is worth. When banks take over properties through foreclosure proceedings, they incur not only attorney’s fees and costs, but also delays and, in today’s environment, possibly more value loss on the property.
For that reason, many Americans like you are looking at "short selling" their homes by bargaining with the bank to eat part of their debt in order to get the house back now. But, at the same time, when a bank reduces the amount it will take to pay off the loan, the reduction in your debt is considered to be income to you that was taxed at ordinary income rates, not the lesser capital gains rates. Your “reminder” would have been reported on an IRS Form 1099-C -- with the “C” standing for “cancellation” of debt.
However, the Mortgage Cancellation Tax Relief Act of 2007 that was signed into law by the President in late December 2007 excludes the forgiven amount from a short seller’s gross income. This public law is complicated, and you should not venture into these uncharted waters without good tax advice.

Bottom line here: You owe income taxes on the forgiveness of the $50,000 note, but not on the short sale. Check with a tax lawyer or your certified public accountant for more information.