So let's say on or after January 1, 2018, you are granted an affordable home mortgage modification that includes a significant principal reduction or that you are granted a short payoff and your loan servicer sends notification 1099-C to the IRS that it has cancelled part of the mortgage debt. Unless the government extends the sunset provisions of the Mortgage Debt Relief Act, you will have to include the cancelled amount as income-so much for an affordable home mortgage modification or for a short sale! So you may have thought you hit the jackpot to only learn that you have to pay some of it back, this time to Uncle Sam. Fortunately there are some exceptions that can prevent this cancellation of debt from being deemed income.
The major exception is if you are deemed insolvent at the time of the cancellation of the debt. Insolvency is essentially when your debts exceed the value of your assets. For example, if you have $100,000 in assets but have $150,000 in debt then you are deemed insolvent by $50,000. Assume further that at the time of this insolvency, the bank is waiving $60,000.00 of debt; consequently, you would have to include $10,000.00 in your gross income for the year the discharge occurred ($60,000-$50,000).
Another exception is a discharge in bankruptcy. A debt discharged in bankruptcy has no income tax consequences to an individual debtor since it is excluded from the debtor's gross income [IRS Code Section 108 (a)(1)(A)]. If you received a discharge in bankruptcy and received subsequently a 1099-C from the mortgage holder or the loan servicer, you will need to file with the IRS form 982 with your tax return. This will notify the IRS that the debt was discharged in bankruptcy.
Another exception is when the debt is a non-recourse loan, which means that you are not personally liable for the debt and the creditor can only enforce his or her rights against the property used to secure the debt. Home mortgages, however, are typically recourse loans and the bank can sue you personally for what is owed over the value of the security assuming the debt is greater than the value of the property. Not everyone fits into the aforesaid exceptions; there are other ways to prevent a cancellation of debt from being deemed taxable income, but this must be done with great care.
As for a deed in lieu or short sale, the IRS treats these as sales, not as a discharge of indebtedness. Generally, speaking, you may have a gain if the amount realized from the sale exceeds your adjusted basis (amount you originally purchased the property for plus any capital improvements made). Conversely, you may experience a loss if the amount realized is less than your adjusted basis. This simple determination of gain or loss also applies to when the property is sold at a foreclosure auction, but there may be additional rules that apply when the fair market value exceeds the amount realized at the foreclosure sale, and in such cases, it is recommended that you speak with a licensed tax professional. Different rules do apply to investment properties such as recapture of depreciation deductions that were previously taken, determination of one's adjusted basis in a Section 1031 like kind exchange, etc. It should be noted that when there is a gain, you may be eligible for the Home Sale Gain Exclusion. This tax break permits you to exclude up to $250,000.00 in capital gains and up to $500,000.00 if married and filing jointly. In order to be eligible, you must own and occupy the property as your primary residence for at least two years during the last five years prior to conveying the deed in lieu or closing on the short sale. See IRS Publication 523 for a detailed explanation: http://www.irs.gov/publications/p523/ar02.html
Below is an excellent article written by the creators of Turbo Tax: https://turbotax.intuit.com/tax-tools/tax-tips/Home-Ownership/How-to-Avoid-Taxes-on-Canceled-Mortgage-Debt/INF12033.html
Consulting with an experienced New York foreclosure lawyer and tax consultant are highly recommended.