Canceled debt's tax impact

Bad news for investors, cash-out refinancers

DEAR BENNY: I am in the process of preparing my income taxes, and heard that I may have to pay a tax on the moneys that my lender canceled when I sold my house via a short sale. Is this correct? –Theresa

DEAR THERESA: I have to give you a good lawyer’s response: "It depends." Usually under the tax laws, if your debt is canceled or forgiven, that is taxable income to you.

However, Congress thought this was absurd: You lose a house by foreclosure (or short sale), and to add insult to injury, you have to pay tax on this phantom income. Accordingly, under the Mortgage Forgiveness Debt Relief Act of 2007, you may be able to exclude up to $2 million — if that debt was on your principal residence.

If the debt was on a second home or an investment property, then you are out of luck; the amount that was forgiven (or canceled) is taxable income to you.