[As is common, please consult a tax consultant to discuss your own peculiar situation]
As we may know now that the Obama administration and private lenders now actively considering mortgage principal-reduction programs to help financially distressed homeowners. However, the Internal Revenue Service has issued a new advisory to taxpayers who sells homes in short sale or via surrender deed in lieu of foreclosure.
The federal tax code generally treats any forgiveness of debt by a creditor in excess of $600 as ordinary taxable income to the recipient. However, under legislation that took effect in 2007, certain home mortgage debt cancellations ” such as through loan modifications, short sales or foreclosures” may be exempted from tax treatment as income. Sheila Bair, chairman of the Federal Deposit Insurance Corp., recently confirmed that her agency is working on a new program to expand the use of principal mortgage reductions to keep underwater borrowers out of foreclosure.
The Tax Implications: IRS guidance issued March 4 spelled out, step by step, how financially troubled and underwater borrowers can qualify for tax relief when a lender agrees to lower their debt. Now, folks who are considering a short sale or loan modification or any other quick way to shed away or walk away from their homes (some calling it strategic default), must think the following before they do anything in this regard.
1. The federal tax exclusion only applies to mortgage balances on your principal residence ” your main home” and not on second homes, rental real estate or business property.
2. The maximum amount of forgiven debt eligible under the law is $2 million for married taxpayers filing jointly and $1 million for single filers.
3. Your debt reduction can only be for loan amounts that you’ve used to “buy, build or substantially improve your principal residence.” This includes refinancings that increased your total mortgage debt attributable to renovations and capital improvements of your house.
4. Let us say if you used the proceeds for other personal purposes, such as to pay off credit-card bills, buy cars or invest in stocks, the mortgage debt attributable to those expenditures is not eligible for tax exclusion.
5. Again, let us put another way, if you refinanced and used some of the proceeds to purchase a boat and pay off business debts. Those expenditures would not qualify for the tax-relief provisions because they were not intended to substantially improve your house or build a residence.
6. The lender is required by law to issue you an IRS Form 1099-C, a “Cancellation of Debt” notice, which is also sent to the IRS.
7. The form shows not only the amount of debt discharged but the estimated fair-market value of the house securing the debt as well.
8. If you’ve been foreclosed upon or you do a short sale and you lose money in the process, don’t claim a tax loss on your federal filing. The IRS will turn you down.
9. However, if you go to foreclosure and your lender agrees to cancel all or part of the unpaid mortgage balance as part of the deal, then you can file for an exemption from the IRS.
10. What if your lender reduces the debt on your house but you continue to own the property and live in it? There’s a tax wrinkle in the fine print: The IRS will require you to reduce your “basis” in the house ” your “cost” for tax purposes” by the amount of the forgiven debt.
11. Finally, if you want to claim the debt forgiveness exemption, download IRS Form 982 (available at http://www.irs.gov) and attach it to your return for the year in which the debt was forgiven. And don’t assume this tax-code benefit to homeowners will be around forever. It expires at the end of 2012.