The February 2012 existing home sale figures indicate that 34% of the homes sold were at deep discounts (20% due to foreclosures and 14% due to short sales). Homeowners that are currently underwater need to be aware of the tax break that is scheduled to expire at the end of 2012.
The tax break for homeowners underwater
The Mortgage Forgiveness Debt Relief Act of 2007 generally allows homeowners to exclude the income realized as a result of the cancellation of debt on their mortgage. Before the act went into effect, borrowers were usually on the hook for taxes when their debt was discharged. For instance, a $750,000 mortgage holder in the 35% tax bracket that could only sell their home for $500,000, would ordinarily owe $87,500 in taxes for the cancellation of debt. The only way that the borrower could have avoided the tax liability would have been to declare personal bankruptcy or to claim insolvency. Thanks to the Mortgage Relief Act, borrowers can exclude up to $2 million of forgiven debt and $1 million if married filing separately on their primary residences (second homes and investment properties don’t apply). The exclusion may not last much longer as it is scheduled to expire at the end of 2012 unless Congress steps in and renews it. That is why borrowers significantly underwater may want to consider negotiating a principal reduction with their lender now (i.e. cancellation of debt).
If my debt is discharged, will I definitely be off the hook for taxes?
If you’re able to negotiate with your lender and they approve a principal reduction to your mortgage, then most likely you will not have to pay any taxes on the cancellation of debt. But, home equity loans that were used for anything other than home improvements and repairs do not count. For instance, if you used part of your home equity loan for personal expenses, then those funds would still be taxable.
What if I have a short sale or foreclosure?
The same exclusion applies to these borrowers, but it can get complicated for those that live in a recourse state. There are 41 recourse states including the District of Columbia in which the lender can sue for the balance of the debt even after the home went through a short sale or foreclosure. Borrowers can only claim the exclusion if the lender agrees to cancel the debt or if the statute of limitations to collect the debt expires, which can take years.
What about at the state level?
Just because the federal government passed the Mortgage Relief Act, doesn’t mean states follow the same standard. Borrowers need to consider their state’s policy as it relates to the cancellation of debt.
How is the cancellation of debt reported?
The lender will send borrowers a Form 1099-C detailing the cancellation of debt and then the borrower should report it on Form 982 for federal tax purposes.
More Tax Questions? Browse answers or ask debt relief tax questions online.
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