Tax on Forgiven Foreclosure Debt May Return in 2014

During the severe and ongoing housing market crisis millions of homeowners found themselves “underwater” on their mortgages, owing more than the market value of their homes. That made it virtually impossible to qualify for refinancing or to sell the home and generate enough money to pay off a burdensome loan. The inevitable result was the financially harsh and oftentimes emotionally devastating outcome of foreclosure.

In some cases, however, there may be a solution.  Your bank may agree to modify the terms of your existing mortgage to make it possible for you to repay it in a more manageable way. They may forgive a portion of that debt, for instance, to give you immediate relief. The lender may also agree to let someone purchase your home for less than the amount you still owe on it, and then forgive or waive the remaining balance. That is usually referred to as a “short sale.”

If you owe $200,000 on your mortgage, for example, but your home’s market value is only $150,000 then a buyer may be willing to pay you $150,000 and the lender may authorize that sale. After the transaction is completed the lender forgives the balance of $50,000 that still remains. You have basically been given a chance to cut your losses without owing the leftover amount that had you “underwater.”

The IRS Taxes Forgiven Debt

Even though the lender is willing to forgive and forget that extra debt though, the IRS sees it differently and treats the forgiven amount of money as ordinary income. The lender has to send the IRS a 1099-C form that notifies them of the amount of debt that was waived or cancelled, and the IRS can then tax you on that “phantom income.”

In the example above, the $50,000 balance the lender did not require the borrower to pay would be interpreted by the IRS as income that the taxpayer must declare for that particular year. The problem with that is that most people who cannot even afford to pay their mortgage also cannot possibly afford to pay taxes on a huge amount of money that they did not actually earn. Although the $50,000 used in our example represents a major financial relief for the borrower, it is not spendable income or cash in their pocket. When the tax bill on that substantial amount of money arrives, they may find themselves broke and back in serious financial trouble – this time with the IRS.

The Mortgage Debt Relief Act of 2007

Congress passed the Mortgage Debt Relief Act of 2007, an emergency bill that states that eligible homeowners are exempt from paying taxes on mortgage debt that was forgiven by their lender. Generally speaking, the Act excludes income that resulted from the discharge of debt on someone’s principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, also typically qualifies for relief from taxes under this legislation. The Act applies to debt forgiven in calendar years 2007 through 2013, in amounts of up to $2 million or $1 million for couples who are married, but filing separately.

Congress May Let the Mortgage Debt Relief Act Expire

There is a problem now, though, and you can blame Congress; members of Congress have not yet extended the Mortgage Debt Relief Act, which officially expired on the first day of 2014. Unless they agree to continue the provisions of the Act, that tax relief will go away. That means if you are planning to use a strategy that involves mortgage debt forgiveness this year, you may have to calculate your federal tax liability into that equation. For most people considering a short sale, for instance, that additional expense to the IRS will undermine the whole process so that it will no longer be a viable option or a financially realistic and doable solution.

How to Declare Forgiven Debt

Forgiven loan debt has to be declared for the year in which it was forgiven, so if you experienced loan forgiveness in 2013, now is the time to include that in your tax preparation. If you have not yet received a copy of the 1099-C form from your lender, that is no excuse because the lender probably did send the information to the IRS. The good news is that your lender-forgiven mortgage debt is probably not taxable as long as your mortgage was used to buy, build, or substantially improve your primary residence. Formally declared bankruptcies and insolvencies may also qualify as exclusions.

Consult a qualified tax planner or visit the IRS website for more details and a better understanding of the rules as they are stipulated under the Mortgage Debt Relief Act. Keep in mind that state taxes may also be owed, although many states follow the same basic rules that apply to federal taxes. You will have to consult your own state’s tax code to determine whether you owe anything in your local jurisdiction.