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Understand the Tax Implications of “Forgiven” Mortgage Debt

With housing prices tumbling nationwide, many homeowners are faced with owing more than what their house is worth. Others are finding that their adjustable rate mortgage that seemed so affordable when they first moved in is no longer manageable now that it has adjusted.  If you find yourself in a similar situation, be sure to understand the tax implications involved before making any major decisions like letting your home go to foreclosure, selling your house for less than you owe, or restructuring your loan through a loan modification.

When a home goes to foreclosure, the lender will often forgive the difference of what is owed and the amount of money they end up receiving when they re-sell the home. Generally, tax law treats any type of debt forgiveness as a financial benefit, and therefore taxable income. As a result the lender would then issue a form 1099-C to the borrower who has to report that amount as income when filing taxes for that year. For example, if the borrower owes $100,000 and the bank sells the foreclosed home for $70,000, the borrower would be liable for $30,000 of additional “income” at tax time.

Currently, the Mortgage Forgiveness Debt Relief Act of 2007 allows the borrower to exclude this debt as long as the home is their primary residence. However, this Act is set to expire on January 1, 2013 and since the foreclosure process is not always fast moving, action taken in 2012 could easily carry past the expiration date.

In addition to foreclosure, some other circumstances where a borrower could have debt forgiven potentially covered by this Act are:

  • Short sale –Where the bank allows the borrower to sell the property for less than they owe on the property with the understanding that the lender will forgive the difference in the principal owed and the selling price.
  • Loan modification - A loan modification is when a loan’s terms, such as the interest rate, monthly payment, terms, or in some instances, principal are altered with the approval of a lender. Typically loan modifications will reduce the interest rate of the loan; consequently reducing the monthly payments.

The details of this Act can get complicated, because only the debt that was used to purchase or improve the home is covered. So what you used the funds you borrowed for is important. If you refinanced and took cash out to pay for your daughter’s wedding, that portion of the money would not be exempt from taxation if forgiven. So, if you have a similar situation, you should probably seek professional tax and /or legal advice before proceeding with a foreclosure and expecting the forgiven debt not to be taxable.

According to the IRS, there are some situations where the cancellation of debt is not taxable. Some of these are:

  • Bankruptcy - debts discharged through bankruptcy are not taxable
  • Insolvency - If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. (You are insolvent when your total debts are more than the fair market value of your total assets.)

Keep in mind that the Mortgage Forgiveness Debt Relief Act also only applies to federal tax liability. Individual states will have their own laws as it applies to forgiven debt, so be sure to check the specific laws of your state. Most states maintain a website that you can locate online by typing your state’s name or abbreviation and “.gov” into any major search engine. Once there, you can search for taxes and “forgiven mortgage debt” to see how it is handled at your state level.

If you are having trouble keeping up with your mortgage payments or find yourself in a situation where you owe more than your home is worth, be sure to consider all the implications before deciding what action to take. It’s not only that you might lose the money you have already invested in the purchase and maintenance of your home, but depending on the current tax implications, you might find yourself out of a home and saddled with an additional  tax burden. You can read more regarding the consequences of home foreclosure and the cancellation of debt on the IRS website.

Please Note:This information is provided for informational purposes only and should not be construed as legal or tax advice.  If you have questions concerning your situation, you should consult with your tax and/or legal advisor. There may be additional information that you can use on the IRS website.


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