What is the Mortgage Foreclosure Debt Forgiveness Act?
Prior to 2007, if a homeowner did a “short sale” (where a house is sold for a lower balance than is owed), Uncle Sam would tax any amount that was forgiven. Why? Because the government viewed the forgiven amount as income, and you bet Uncle Sam wants you to pay as much in taxes as possible. In 2007, in order to help the melting economy, Congress passed the Mortgage Foreclosure Debt Forgiveness Act. This law provided that homeowners would not have to pay taxes on what was essentially ‘phantom income.’ This encouraged home owners to sell their homes if they were under water without having to worry about a tax bill.
Now, the Debt Forgiveness Act is set to expire. So – if homeowner owes $300,000 on a home currently only worth $200,000, and the home is short sold for $200,000, the owner will owe taxes (almost $30,000!) on the forgiven debt of $100,000. In California, according to the website Property Radar, 1 in 4 home owners are still under water. You can see then that the expiration this law will have an effect on many people.
Don’t think that Congress had your best interest at heart when they passed the Debt Forgiveness Act. Sure, home owners benefitted, but what Congress was really trying to do was stop a hemorrhaging economy – even at the expense of losing out on revenue via taxes on homes that were short sold. This is why the law was temporary – because Congress’ intent was never to stop taxing home owners on ‘phantom income.’ What will most likely happen now that the law is set to expire – especially because the economy is still teeter-tottering - is that home owners will have very little incentive to short sell. Instead, they’ll just default and eventually walk away or get foreclosed on since either way, there will be a deficiency they’ll be taxed on. On a national level, this phenomenon may destabilize communities, causing home values to go down because of an increased number of foreclosed, dilapidated and vacant homes.
What to do if you’re one of the estimated 10 million homeowners nationwide potentially facing this dilemma?
One, you might still qualify for tax relief if you can prove you were legally insolvent at the time of the short sale. Legal insolvency, in the eyes of the IRS, is when your total debts are greater than the value of your total assets (such as personal property, pension amounts, retirement accounts, and the like). Talk with a tax professional to get more information about this option and whether you might qualify (remember, it will be up to the IRS to determine your qualification).
Two, bankruptcy offers tax relief because you can avoid tax liability on debt that is discharged through bankruptcy. With the example above, instead of paying a tax bill of approximately 30k, the home owner could avoid that tax liability by filing bankruptcy. Bankruptcy is not something most people want to do, but it may be a necessary step to take. Talk with a bankruptcy attorney to explore this option.
Either way, know that you might have a couple of options if Congress doesn’t renew or retro-actively change the law here in the next couple of weeks or early next year.