There is also another way homeowners may be able to "exclude" certain types of cancellation of debt from taxable income, and Congress recently extended this exclusion as part of the it's latest tax and spending bill.
While that's good news for many homeowners, the exclusion covers only a very specific type of cancelled debt called "qualified principal residence indebtedness" (QPRI). First enacted in 2007 as the real estate bubble burst and foreclosures were becoming more common, the QPRI exclusion allows borrowers to avoid taxes on COD income, but only if the debt cancellation was for a mortgage that secured their main home, and only as long as it was originally taken out to buy, build, or substantially improve that home. The QPRI exclusion also applies to any debt secured by a main home that was used to refinance a mortgage taken out to buy, build, or substantially improve the main home, but only up to the amount of the old mortgage principal just before the refinancing.
Because of the limitations on the QPRI exclusion, a lot of people who had tapped their home equity for purposes other than refinancing a purchase money mortgage or home improvements are not able to take advantage of it.
The QPRI exclusion had expired at the end of 2014, but Congress recently extended the law through the end of 2016, so anyone with qualifying COD income in 2015 or 2016 will be able to take advantage of the exclusion. The new law also includes language that covers "an arrangement that is entered into and evidenced in writing before" the end of 2016. Presumably, this would cover a situation where an agreement for the cancellation of debt in connection with a deed-in-lieu of foreclosure or short sale is signed in 2016, but doesn't close until after the end of the year. This is a potentially helpful planning device that was missing from the original law.As I described in more detail in my last post, debts discharged as part of a bankruptcy never result in taxable COD income. However, once the bank cancels a borrower's debt outside of a bankruptcy, assuming it's a taxable event, those taxes cannot be discharged in a bankruptcy commenced in the next three-plus years. As a result, timing is critical, and a bankruptcy filed prior to receiving a 1099-C from the bank can be an effective strategy for avoiding taxes on COD income.