Foreclosures | Debt Forgiveness
If you are a homeowner whose residence was foreclosed or you short sold your property, you may be wondering what the consequences are regarding the difference between the remaining principal owed and what the property eventually sold for. Your financial institution has a few options the most prevalent one in the case of a foreclosure is a deficiency judgment. The other prevalent option in the case of a short sale is to forgive the debt owed. This article was written with the assistance of Eric Matthews, Broker for Gulfcoast Realty International and will explain why you might want to suggest to the lender to forgive the debt.
Historically speaking, when a debt is forgiven (other than a bequest or gift), it is recognized as income by the IRS. The reason for this is that when you take out a loan you receive money and if you do not pay the full amount back, the amount that is not paid back is essentially money in your pocket. This is considered income and is taxable by the IRS. In the case of a loan for the purchase of your home, the amount that was loaned to you and not paid back is considered income. This creates a potential problem if the taxes on the income are not paid to the IRS, because they will have a right to levy your property to make up the shortage.
However, congress created the Mortgage Forgiveness Debt Relief Act on December 20, 2007. This little known relief act allows taxpayers to exclude debt forgiven on their principal residence (homestead) if the balance of the loan is $2 million or less. The excluded amount is $1 million for a married person filing a separate return. In essence, if the principal of your loan is less than $2 million and the lender forecloses or you short sell your homestead property, the amount of your loan (if forgiven by the lender) is eligible to be excluded as income. Other debts that may qualify for the income exception include student loans, farm indebtedness, certain real property business indebtedness and circumstances where you can demonstrate insolvency at the time a debt is cancelled.
Even if your lender agrees to restructure your loan by reducing your debt it may qualify for the Mortgage Forgiveness Debt Relief Act. This often occurs where the lender refinances the loan on your homestead by reducing the principal balance, interest rate or monthly payments to allow you not to lose your home. As an example, suppose your lender agrees to refinance your loan, if the refinancing results in a cancellation of part or all of the previous debt, your forgiven debt will likely be eligible to be excluded as income up to the amount of the principal balance owed on the old loan at the time of refinancing. The resulting income tax savings are potentially huge to you as a taxpayer.
The Mortgage Forgiveness Debt Relief Act covers those failed mortgages for the years 2007, 2008 and 2009. Fortunately, congress acted swiftly enough to continue the Debt Relief Act by enacting the Emergency Economic Stabilization Act of 2008 which continued the treatment of the Debt Relief Act through the end of 2012.
Naturally there are some criteria that need to be met before you can qualify for the income exclusion. The general criteria to qualify for eligibility under the Mortgage Forgiveness Debt Relief Act is: 1) the debt being forgiven must have been a loan secured by your primary residence (homestead); 2) the amount of the original loan cannot exceed $2 million for a married couple; 3) The funds received from the loan must have been used to buy, build or substantially improve your homestead property (loans on your home that were used to buy a car may not be eligible); and, 4) The debt being excluded must have been a loan on your homestead.
Even if only part of the forgiven debt meets the criteria for income exclusion, the un-forgiven portion may qualify under the Debt Relief Act if you can show that you are insolvent (debts exceed assets) at the time your debt was forgiven. The insolvency qualification of the Debt Relief Act can be used to relieve you of credit card debt that was cancelled while insolvent. In addition, if the debt is discharged in a Title 11 bankruptcy proceeding, it may also qualify for income exclusion under the Debt Relief Act. This may occur if you have a car loan and the debt is cancelled as a result of the Title 11 bankruptcy proceeding or you were insolvent just before cancellation of the principal balance owed on the loan.
Second homes, rental property, business property, do not qualify for the tax forgiveness debt relief act. Generally speaking credit card debt and car loans are not excludable unless you can qualify as insolvent immediately before the debt is cancelled. The income exclusion does not apply if the discharged debt is due to services performed for a lender or any reason not directly related to a decline in your homestead’s value or financial condition (insolvency).
If your loan is forgiven, your lender will provide you with a 1099-C statement at the close of the year. The purpose of the 1099-C is to inform you of the amount of debt being forgiven and the fair market value of the property foreclosed. When you receive your 1099-C statement, look at the amount forgiven in Box 2 as well as the value of your home listed in Box 7. If any of this information is incorrect, notify your lender at once.
Although the above sounds great you will need to be wary of the situation where your lender takes back your property in full or partial satisfaction of your debt (e.g deed in lieu of foreclosure and foreclosure). In such situations you will also be treated by the IRS as having sold your property. Depending on the fair market value of the property versus the principal balance of the loan and any depreciation (if any), you may be facing a capital gain or loss. This must also be dealt with as a separate issue from the cancellation of your outstanding debt and reported on your annual 1040 filing.
If you elect to take advantage of the income exclusion, the author strongly recommends you consult with a tax advisor or attorney. If you elect not to consult with an attorney, you should obtain from the IRS the following publications, 544, 4681, 982 and 1082. Whatever your election, the government has provided an excellent tool to save you thousand’s of tax dollars in these turbulent economic times.