Ever since the housing market tanked a few years ago, we’ve all heard or read about the explosion of mortgage foreclosures and short sales. For those of you who have not experienced this for yourself, imagine the surprise if you were relieved of a crushing debt that you had no cash flow for, only to find out that you now owed tax on that forgiven debt! The Mortgage Forgiveness Debt Relief Act of 2007 (“The Act”), addressed this issue, but “The Act’s” provisions will end when 2012 does, so I figured I’d give everybody a quick reminder of what “The Act” does.
Generally (one of IRS’s favorite words) forgiven debt is considered taxable income to the person who no longer has to pay the debt. For example, if you rack up $5K of charges on your credit card and then can’t pay it, and the bank forgives that debt, they’ll send you a Form 1099-C (Cancellation of Debt), and you will have to pay tax on that $5K of ‘income’. The same has held true for cancelled mortgage debt, until the “The Act” came into being.
The provisions of “The Act” allows for discharge or reduction of mortgage debt to be tax-free. As with anything coming from Congress or IRS, there are plenty of rules. Here are a few:
1-The provisions of “The Act” only apply to debts forgiven during tax years 2007 through 2012.
2-Up to $2 million of debt can be forgiven ($1 million for a married person filing a separate return).
3-The debt can only be on your principal residence. It cannot be for a second home, a rental property, business property, credit cards, or car loans.
4-The debt must have been used to buy, build, or substantially improve your principal residence, and be secured by that residence.
5-Proceeds of refinanced debt used to substantially improve your principal residence qualify, but proceeds used for other purposes (for example, to pay off credit card debt) do not.
To claim the exclusion, a form needs to be attached to your tax return, and obviously the proper underlying information must be kept, to support the tax-free treatment on a tax return. It can be a tremendous financial weight off one’s shoulders to not owe tax on mortgage debt forgiven in a foreclosure, but the rules need to be followed, and the clock is ticking toward the end of “The Act’s” provisions.
I hope you found this information helpful, and please pass it along to anybody you know who is currently struggling to pay their mortgage. As always, let me know if you have any subjects you’d like to see me write about.