The current housing market is full of foreclosed homes and properties that have plummeted in value. In fact, it has been reported that the real estate market has a negative equity gap of about $3.7 trillion, with millions of homeowners underwater on their mortgage loans. The good news is that if you are a struggling homeowner, there may be some relief in sight.
If you owe a debt (such as a mortgage loan) and the lender cancels or forgives part of that debt, the discharged amount (which you no longer owe) may still be taxable according to the IRS. Under the Internal Revenue Code, all types of forgiven debt are still treated as income and subject to taxes.
Enter the 2007 Mortgage Debt Relief Act, which was recently extended to be effective until the end of this year (December 31, 2013). This bill allows taxpayers to exclude income (on their tax returns) from the discharged debt on their principal residence. This can include debt that is reduced by mortgage restructuring as well as debt that is forgiven relating to a foreclosure. If the Mortgage Debt Relief Act had expired, any amount of cancelled debt would be considered taxable income for IRS purposes.
The Mortgage Debt Relief Act applies to the following:
- Homeowners who are granted principal forgiveness on their mortgage loan
- Homeowners who do a short sale on their home
- Homeowners who do a deed-in-lieu of foreclosure on their home
- Homeowners who have lost their home to foreclosure, or are in the process of foreclosure
If you are looking for mortgage forgiveness, you now have less than 12 months to take advantage of this tax relief. And while it may seem like you have a lot of time between now and December, keep in mind that short sales can take up to 6 months (or more) to complete. A loan modification or a deed-in-lieu of foreclosure can take at least 3 months to finalize, and a foreclosure can take up to a year to complete.
You may be able to exclude up to $2 million of forgiven debt from your taxable income (or up to $1 million if you are married filing separately). Note that this exclusion does not apply to debt that is cancelled for any reason that is not directly associated with the homeowner’s financial situation or a drop in the home’s value.
The Mortgage Debt Relief Act affects 4 main types of situations:
- Principal forgiveness
- Deeds-in-lieu of foreclosure
- Short sale
In certain cases, the mortgage lender may decide to cancel or forgive part of your debt. This can provide helpful financial relief for struggling homeowners who may no longer have to default on their mortgage loan. With the Mortgage Debt Relief Act, any debt that has been forgiven by your mortgage lender can be excluded from your income and will not be subject to taxation by the IRS. This means that you will not have to pay taxes on debt that you technically no longer owe.
Sometimes borrowers find that they are no longer able to make their monthly mortgage payments.
This could be due to a dire financial situation (such as a job loss) or because the mortgage terms were automatically modified (which is what occurs with adjustable-rate mortgage loans resulting in higher monthly payments that are now unaffordable. If the borrower defaults on their loan, the mortgage lender has the legal grounds to initiate a foreclosure on the property. Under the Mortgage Debt Relief Act, any debt that is forgiven in association with a foreclosure can be excluded from your income and will not be subject to taxation.
A deed-in-lieu of foreclosure is an alternative to foreclosing for homeowners who can no longer afford to make their mortgage payments. With this option, the delinquent borrower surrenders all interest in the property to the lender (who now takes over the home) in exchange for releasing the borrower from their mortgage debt obligation. A deed-in-lieu of foreclosure satisfies the loan in default and it may be less harmful to your credit score (than traditional foreclosure).
This alternative also helps you avoid going through the entire foreclosure process and proceedings. If the mortgage lender decides to forgive the deficiency balance (resulting from the sale of the property) as part of your deed-in-lieu of foreclosure arrangement, the IRS still generally considers the forgiven amount as part of your taxable income. Fortunately, the Mortgage Debt Relief Act allows qualified taxpayers to get an exception from paying tax on debt that is forgiven in relation to a deed-in-lieu of foreclosure.
A short sale is another alternative to foreclosure that struggling homeowners may consider. With a short sale, the home is sold for less than the balance remaining on the mortgage loan. The lender agrees to accept less than the amount owed on the mortgage loan, and the borrower receives no money from the sale, but avoids having to go through a foreclosure.
If the mortgage lender decides to forgive the deficiency balance (resulting from the sale of the property) as part of your short sale arrangement, the IRS still generally considers the forgiven amount as part of your income that is subject to tax. The Mortgage Debt Relief Act permits taxpayers to exclude the amount of forgiven debt from their taxable income.
Use IRS Tax Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness, and Section 1082 Basis Adjustment) to claim the mortgage forgiveness tax break. On this form you can report the exclusion of forgiven debt for your mortgage loan that is associated with principal forgiveness, foreclosure, a deed-in-lieu of foreclosure, or a short sale. Note that you will only need to fill out part of Form 982 because it is also used for other purposes. Complete the appropriate lines and then attach Form 982 to your regular income tax return.
For more information about mortgage forgiveness and the 2007 Mortgage Debt Relief Act, please refer to the following documents:
- IRS News Release IR-2008-17
- IRS Publication 4681 (Cancelled Debts, Foreclosures, Repossessions, and Abandonments)
Elizabeth Rosen grew up near Boston and comes from a family of financial planners. She attended Carnegie Mellon University in Pittsburgh, Pa. where she studied professional writing. After graduation, Elizabeth moved to San Francisco where she worked for several years as the senior writer/editor and content manager for an online company. She now lives in Los Angeles working as a financial writer for numerous websites and print newsletters.