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It's Tax Time Again. What To Do With Your Cancelled Mortgage Debt?

By Jordan Taylor

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Published: 11Jan2012
Word count: 4547
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It's been a pretty rough year for so many Americans. The economy is definitely in a slow down, and more people than ever before have had to live through the turbulent ride of this real estate market. Thousands have lost their homes to a foreclosure or short sale, and now that it's time to get ready for the taxman, it's time for them to figure out the tax implications these mortgage relief programs will have on them this tax season. If you're one of the many Americans facing this scenario when you file your 2011 taxes, you may just have received a very special Christmas gift from the U.S. Government.

Before this unprecedented rollercoaster ride we like to call the real estate market boomed and then busted, people who were foreclosed on got hit with a double whammy. Specifically, this meant that the homeowner may have had their home mortgage cancelled by the bank, but their year-end gift was sizeable taxable income, courtesy of the IRS. But in 2007, legislation known as the Mortgage Debt Relief Act of 2007 was passed that essentially did away with the whole no house, more taxes, and extra pain combination.

Here's what homeowners dealing with a foreclosure had to look forward to prior to the Mortgage Debt Relief Act of 2007. You bought your dream house for $500,000, putting no money down, and your banker suggested you take out a $500,000 interest only mortgage so that you could afford the payments. Of course, they would have also told you how a home is always a great investment, and that you would be able to lock in some kind of low interest rate further down the road. Later, when the market tanked, and you couldn't make the mortgage payments any more, the bank is happy to step in, foreclose on your loan, and take the house back.

Okay, that scenario sounds all too familiar. So what happens next? Well, once the bank foreclosed, and sold your house for $300,000 (yup, that's a whooping $200,000 less than you borrowed from them in the first place), that unpaid difference is out there lurking, waiting to be paid by someone! So the $200,000 deficiency could be monies you are responsible, because they were not paid back on the mortgage. If you're lucky, or the bank doesn't believe you're solvent, they may cancel the debt, because they consider it uncollectable. So far, that sounds okay. You just walked and may not be on the hook for that other $200,000.

Hang on for a minute though; you still need to steer clear of the tax trap. The 2007 legislation helped ease the foreclosure sting, however, there is always a BUT. In this case, that but is that the new law only covers six years (yes, if you're counting in your head, that means it's set to expire in 2012), after which time` the old law takes affect again.

So how do you know if the new law affects you? The first qualifier is that the property must be your principal residence. That doesn't mean you can't have a loan forgiven, foreclosed on, restructured, or short sell your property if it's a vacation home or investment property, but it does mean that the old rule will apply if the property does fall into that category. The total amount of debt cancelled in a scenario where the property is not your primary residence would be considered taxable income, unless you happen to fall under one of the exceptions (see below). Another restriction is that no more than two million dollars will be forgiven on a principal residence; if the amount you have forgiven exceeds that dollar amount, the remainder would be considered taxable income. Next, to be considered non-taxable, your principal residence should secure the loan and the money must have been used to improve your home. If part of your debt forgiveness were a home equity loan used for purposes outside of improving your primary residence, it would be considered taxable income. Finally, the "tax" or "cost" basis of your home is diminished by the dollar amount of the debt that was excluded from your income. You will look at this basis amount when you compare the selling price for your home to see whether you had a profit or loss on the property. In tax terms, this means a foreclosure would be treated much like the sale of your property. So if you ended up having $100,000 in debt forgiven, cancelled, or foreclosed on, your basis would be reduced by $100,000. That means the profit you have to report when you sell your home would have to be increased by the $100,000 you were forgiven in your debt cancellation.

If you had more than $600 in debt cancelled in a given year, you'll be issued a 1099-C form in about January or February of the year after your debt is forgiven or cancelled. That's so that you can put it together with the rest of your tax forms! This form shows how much debt was forgiven, and also includes the fair market value of the property you gave up to the lender in a foreclosure. You should look over this form thoroughly and make sure you inform the lender right away if there is anything incorrect on the form. The two places you need to watch for in particular are Box 2 (the amount of debt forgiven), and Box 7 (the value listed for your property).

A short sale is a unique way for the borrower to get the lender to sell the house for less than the original mortgage balance. Hence the term "short sale". Think of it this way, you lost your job, or took a huge cut in pay just to keep it. Needless to say, your $500,000 mortgage balance didn't take the same hit as your income, even though the value of the property did decline. In fact, that same property is probably worth more like $280,000 today. If your lender agrees to allow you to short sale your property, you're looking at listing it, paying the commission and associated selling fees, then turn the remaining deficiency balance back over to the bank. If the bank forgives that amount (say it's somewhere around $200,000), then that $200,000 would be listed as cancelled debt on your 1099-C. That means the $200,000 is considered taxable income (ouch!). Thanks to the 2007-2008 tax changes, short sales that take place between 2007-2012 and fall into the category of a primary residence, then those individuals will not have to account for the $200,000 in cancelled debt taxable income.

What happens if you don't fall within the principal residence exception? Well, you may fall into one of the exceptions to the taxable income rule. For example, cancelled debt is not construed as income, even if you get a 1099-C if you received the cancelled debt due to a bankruptcy filing, or to the extent you are insolvent just prior to cancelling the debt. What does that mean? It means you are insolvent if your debts are greater than the value of all your assets. You can seek to exclude cancelled debt as taxable income up to the amount you are considered insolvent. Here's what I mean, if you have assets totaling $450,000 on that mortgage debt of $500,000, you would be considered insolvent by $50,000. So if you ended up having $200,000 in debt cancelled while in this state of insolvency, you would have to include $150,000 ($200,000-$50,000) in your income. It is important to make sure you understand what your tax liability might be if you end up cancelling any portion of your debt resulting from this downward spiraling mortgage market. Make sure you work with a competent tax professional, or use a qualified service or provider to help reduce the amount of stress you might experience during this years tax season. There is no guarantee that the US government will extend this program, so the number of short sales in 2012 could increase dramatically.

Jordan Taylor is a freelance writer specializing in legal special interest articles for Las Vegas Short Sale Attorneys and Las Vegas Traffic Ticket Lawyers.

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