Shorts Sales & Deeds in Lieu may be costly, perhaps Bankruptcy is a better option: The Income Tax Consequences of Discharging your Mortgage Debt
Short sales and deeds in lieu are both popular options of freeing a homeowner of mortgage debt as an alternative to mortgage foreclosure. For example, consider a homeowner who bought a home for $200,000 with a recourse mortgage for the total amount. Now lets say that home has a fair market value of only $150,000 and the homeowner is unable to continue making payments on the outstanding $200,000 loan balance. Often in this scenario the lender and the homeowner will reach an agreement whereby the homeowner either surrenders the home at its current value as satisfaction of the loan to the bank (a deed-in-lieu), or the bank agrees to allow the seller to sell the home at its current fair market value which it will accept as satisfaction of the total outstanding loan balance (a short sale). However, this may not be the end of the liability or costs to the homeowner.
The IRS defines taxable gross income in the Internal Revenue Code sec. 61(a)(12) not only as money received, but also as the amount of any debt discharged. What this means is that the homeowner in the above example would realize $50,000 (the difference between the total mortgage balance and the fair market value of the property when transferred or the amount that the bank accepts as satisfaction of the loan) of income during the year of the deed-in-lieu or short sale. Now consider for example this homeowner is a married couple whose combined income is $60,000 a year. This couple would be in the 28% income tax bracket and would pay income tax in the amount of $12,003 for this year. Now take into consideration the $50,000 of debt which was discharged by the deed-in-lieu or short sale. Now the couple's combined income is $110,000 ($60,000 + $50,000 discharged debt). Now the couple is in the 31% tax bracket and will pay income tax in the amount of $26,628.50. Essentially discharging the $50,000 of mortgage debt costs the homeowner $14,625.50 in additional income tax, money which the homeowner often does not have available as cash in order to pay the tax.
Alas comes the Mortgage Forgiveness Debt Relief Act of 2007. The act excludes the discharge of the mortgage debt as income, therefore in our example even after the discharge of the $50,000 debt by deed-in-lieu or short sale, the homeowner's income for that year would still be $60,000 and their tax will remain the amount based on that $60,000. This exclusion enacted in 2007 is effective for debts discharged in 2007, 2008, and 2009. However, the act has its limitations. In order to exclude the income from the discharge of debt the home transferred or sold to satisfy the debt must have been the homeowner's principal residence and the balance of their loan must be less than $2 million if filing as a married couple ($1 million filing separately). Therefore, any debt discharged from a second home or other non-primary residence will be included and taxed as income to the homeowner.
The Mortgage Forgiveness Debt Relief Act applies only to debt that was used and forgiven in order to build, purchase, or refinance an applicable residence. Therefore, a homeowner who took out a home equity line of credit and used the money to buy a car or other non-excluded purchase, and subsequently is forgiven of some or all of the debt cannot exclude this amount discharged as income.
However, the Internal Revenue Code sec. 108(1) also excludes debt discharged in other circumstances from a taxpayer's income, more specifically debt discharged in a bankruptcy case. When a homeowner has debt discharged through a bankruptcy proceeding, that debt amount that is discharged will not be counted as income, even though under normal circumstances that amount would be considered income in the year discharged. Amounts discharged under bankruptcy are not limited as amounts excluded in the Mortgage Forgiveness Debt Relief Act of 2007 are in order to be excluded from income. Amounts discharged in bankruptcy are not counted as income if the amount is a discharge from a primary residence, second home, third home, etc., or even other debts not related to mortgages. So under many circumstances it is beneficial for a homeowner to seek discharge of debts through the filing of bankruptcy in order to not incur substantial tax liability which the debtor cannot pay.
In addition to these exclusions, the homeowner can still be taxed additionally if there is a gain based on the fair market value on the property when transferred from what they had originally paid for it, this situation arises often when the debt is based on a refinance or a mortgage taken out after acquiring the property. For full tax details and implications a homeowner should contact a CPA.
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