My friend Darrin Jaszkowiak, real estate agent with RE/MAX West, called me the other day asking questions I hear often. Here is an edited version of our conversation.

Darrin: First, the Mortgage Debt Relief Act: My understanding is it was extended. Is that correct?

Peter: The special provision that gave relief to individuals who were having debt issues with their personal residence was set to expire at the end of 2012. The American Taxpayer Relief Act that was just passed on Jan. 1 extended the relief provision through 2013. So we still have another year to take advantage of this favorable tax law.

Darrin: I’ve run into a few common misconceptions for folks who either are experiencing foreclosure or a potential short sale. The thing that seems to come up is that there is a possible tax consequence when debt is forgiven. Can you just explain that briefly?

Peter: Many people believe if they negotiate with the bank and get out from under their debt they can just walk away. But the tax laws aren’t so kind. You have derived an economic benefit from that cancellation of indebtedness, and consequently there is income that potentially has to be picked up on your tax return.

Darrin: And that is the same consequence whether the property goes to foreclosure or short sale. Is that correct?

Peter: That’s right. The tax consequences are very similar.

Darrin: But there is a bright side to this and ways around it. The typical scenario that I see with many clients is the client loses his job or becomes underemployed and simply can’t make the house payments. In those situations the house is usually underwater, and the homeowner ultimately decides to short sale. Can you talk about the tax consequences relative to this legislation as it pertains to their primary residence?

Peter: Typically what will happen in a foreclosure or a short sale is that the property is sold for less than the amount of the debt that is outstanding. Consequently, the difference between the sale price and the debt that is outstanding is considered cancellation of indebtedness income. Normally that would need to be picked up in your taxable income, but this special provision allows that if the debt is related to a “qualified principle residence” you actually exclude that income and do not pay tax on it. There are some restrictions on this, but for most people this is a great benefit. And the $2 million cap on this tax-free exclusion is sufficient to cover virtually all residential debt-relief situations.

Darrin: Not every property that is sold is a primary residence, and we often run into people who have purchased investment property, but they have the same scenario above. My understanding is that legislation doesn’t specifically protect them, but isn’t there an insolvency aspect to the IRS code that does provide some protection?

Peter: If the property is not a qualified principal residence, then it won’t fall under the exclusion we talked about. There are several other ways to avoid picking up this cancellation of indebtedness income. One is if you are in bankruptcy, and another is if you are deemed to be insolvent.

Insolvency is not always easy to determine. You need to look at the fair value of all your assets: your bank accounts, your car, your household goods, your retirement accounts and cash value of life insurance. Then you need to identify all of your liabilities: any loans, credit card debt, and unpaid taxes or bills. These liabilities include the discharged debt before the write-down. To the extent that all of those liabilities are greater than your total assets, you are considered to be insolvent. That creates an amount that can be excluded from taxable income.

So there is some good benefit here, but there are some drawbacks that you have to consider. It’s not an extremely simple thing to go through, but it certainly does provided a good benefit for people having financial problems.

Darrin: We also talk to folks who run into what we classify as a strategic default. And those would be clients who have a pretty good income, and they have assets. They don’t really qualify for this insolvency deal. What should they be looking at?

Peter: Usually someone in that situation needs to be reviewed on a case-by-case basis. If you are at that point in your planning, it is time to call in someone who has the experience and can give you some additional guidance on your specific issue.

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To ensure compliance imposed by IRS Circular 230, any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed by governmental tax authorities. The answers in this column are meant to offer general information. You should consult your tax adviser regarding the specifics of your situation.

Peter Robbins is a partner in the Boise office of CliftonLarsonAllen, LLP specializing in tax matters for small businesses, individuals, and trusts and estates.

Have a question for Robbins? Email your question to news@idahobusinessreview.com. Enter “Talking Tax” in the subject line.