Many clients ask me if they will owe income taxes on a forgiven mortgage, either from a foreclosure or a short sale. Generally the answer is yes. The truth is, if a lender forgives any portion of your mortgage, the IRS generally calls that taxable income.
Tax Relief
On December 20, 2007, President Bush signed the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) into law. The Act increases the incentives for borrowers and lenders to work together to refinance loans, and allows American homeowners struggling to make their regular mortgage payments to secure lower payments without facing higher taxes. Provisions of the Act are summarized here.
Discharge of indebtedness on principal residence
The IRS treats all debt amounts that are reduced, forgiven, or eliminated as part of a mortgage restructuring or foreclosure as taxable income. The Act allows taxpayers to exclude this amount and escape the tax liability. Specifically, the Act provides an exclusion for discharges of up to $2 million ($1 million if married filing separately) of indebtedness that is secured by a principal residence. Qualified principal residence indebtedness is debt incurred in acquiring, constructing, or substantially improving the residence. (Cash out refinancing does not qualify for this exclusion.) This tax break applies to debts discharged from January 1, 2007 to December 31, 2012.
If only a portion of the loan discharged is qualified indebtedness, the exclusion applies only to the amount of debt discharged that exceeds the amount of the loan that is not qualified indebtedness.
Example(s): Assume that a taxpayer has a $400,000 loan outstanding on his principal residence, of which $70,000 is non-qualified debt. If $100,000 of the loan amount is discharged, only $30,000 ($100,000 discharged debt — $70,000 non-qualified debt) of the debt discharge qualifies for the exclusion.
Technical Note
The definition of a taxpayer’s principal residence is the same as that under Internal Revenue Code Section 121. Generally, a principal residence is where the taxpayer lives most of the time. Thus, the new law does not apply to vacation homes, second homes, business property, or investment property.
Talk to your CPA to see if you are eligible for these savings. The law is VERY complex. Working with your realtor and your CPA, you can make the best out of a bad situation. If we can help, please give us a call at 734-459-9970.