It has been said that the only two things that are certain in life are death and taxes. And even then, taxes are the worse of the two because, according to Will Rogers, “death doesn’t get worse every time Congress meets.” But a few years ago, Congress actually passed legislation (the Mortgage Forgiveness Debt Relief Act) that would relieve taxes on forgiven mortgage debt, such as in a short sale. Unfortunately, that legislation is scheduled to expire at the end of 2012. Unless extended by Congress, what would expiration of the Mortgage Forgiveness Debt Relief Act mean for you?
Here are some questions that homeowners are asking about paying taxes on forgiven mortgage debt.
How does the Mortgage Forgiveness Debt Relief Act work?
The idea behind this legislation is rather simple and applies most clearly where the bank agrees to extinguish a mortgage loan in order to recover less than the full value of a primary home (ordinarily through a short sale). If you have a home on which you owe $200,000 and you were to sell it as a short sale for $175,000 with the bank agreeing to extinguish the remaining debt, you would ordinarily be responsible for paying taxes on the $25,000 difference because the IRS considers the debt forgiven as income. The Mortgage Forgiveness Debt Relief Act, however, makes that $25,000 in non-taxable. If you are planning on selling your home before foreclosure as a short sale, there is a big incentive to do it before the end of 2012 when the legislation expires.
Do the provisions apply to any forgiven debts related to my mortgage?
No. According to the IRS’s website, the Mortgage Forgiveness Debt Relief Act “applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes.”The debt must also be secured by your home.
Will Congress extend the provision past December 31, 2012?
There are signs that the provision will be extended past December 31, 2012. In fact, the Senate Finance Committee recently passed a one-year extension for the legislation. However, as of right now, Congress has not passed the extension. It is expected to, however, as part of a larger tax measure that is being discussed by lawmakers in the months to come before year’s end.
Are there instances in which the homeowner is still responsible for the taxes?
The Mortgage Forgiveness Debt Relief Act does not apply to all homes that are sold for less than what the homeowner owes on them. If you have a short sale on a home that is not your primary residence (a second home or investment property) or if you have debt forgiven on a home equity line of credit, you are still required to report those monies to the IRS.
Will I be taxed on the difference between my outstanding mortgage balance and the value of my home if my home goes through foreclosure?
There is no short answer to this question. For homeowners who have a recourse mortgage (i.e., a mortgage where the lender can pursue the borrower for any money owed as a result of the difference between the selling price and the amount owed) , any debt that is forgiven is considered as income.
On the other hand, with non-recourse mortgages, the forgiven debt is not considered income to the borrower according the Mortgage Forgiveness Debt Relief Act. With these mortgages, the lender is not allowed to pursue you for the price difference following a foreclosure. The laws regarding recourse and non-recourse mortgages generally depend on the state in which you live.