There are numerous reasons why someone would sell a home for less than what was paid, such as a job transfer, marriage and combining households, or an illness or death in the family.
For many households in and around Phoenix, though, there are two other reasons: they are either underwater on their homes (owing more than the property is worth); or they have lost employment income and default on the mortgage is inevitable. Either of these circumstances can force the owner to sell the primary residence for less than what is owed in a struggle to move over to more affordable housing.
An option for many homeowners is the short sale which entails selling the home for less than what is owed on the mortgage. Short sales avoid foreclosure and often involve the lender forgiving the remaining principal. This allows the sellers to simply walk away from the home. Since 2007, short sales have worked out well for many struggling home sellers, but there is a ticking tax bomb that’s set to go off at the end of this year.
The Basic IRS Rule – If you owe a debt to someone else and they cancel or forgive that debt, the canceled amount may be taxable.
By taxable, we mean taxable as income. If you sell the home at a loss and your lender forgives the remaining principal of the loan, then the amount forgiven is a canceled debt and must be reported as income for the year canceled.
There is a reason why forgiven debt is income for tax purposes, whereas the proceeds of a loan are not taxable income. On the one hand, when you borrowed the money from a lender to purchase the residence, you had the cash proceeds (which you immediately applied to the purchase of your home) – you didn’t owe tax on that money because it was a loan you were obligated to repay.
On the other hand, if the lender forgives a portion of that loan, then you had the cash proceeds (which you used to purchase the house) with no obligation to repay it. That is why the IRS taxes a forgiven debt as income to the initial borrower who’s no longer on the hook for the balance on the loan.
Mortgage Forgiveness Debt Relief Act of 2007
The Mortgage Forgiveness Debt Relief Act of 2007 was signed into law by President George W. Bush the year following the burst housing bubble. The act gave a tax exclusion to those people who sold their principal residences in short sales, who had their loans restructured (principal reduced), or who lost their homes to foreclosure and had the debt forgiven by the lender. The temporary exclusion gives relief from the basic IRS rule that a canceled debt is taxable income.
The Mortgage Forgiveness Debt Relief Act’s exclusion from income tax on canceled debt is significant. Any debt canceled on a principal residence between 2007 and 2012 is eligible for a tax exclusion of up to $2 million (or $1 million if married filing separately). The forgiven debt must be directly related to either a reduction in the home’s value or the taxpayer’s desperate financial situation.
So what is the ticking tax bomb? This debt relief act will expire on December 31, 2012. After that, any forgiven or canceled loan may be taxable as income.
To take advantage of the current temporary tax exclusion, homeowners must complete the short sale, loan modification, or foreclosure with canceled debt before the end of the year. If you plan to short sell your Arizona residence, then initiate the process as soon as possible so escrow closes on the conveyance before the December 31 deadline.
Will Congress Extend the Mortgage Forgiveness Debt Relief Act?
The big question is whether this Congress will extend the Mortgage Forgiveness Debt Relief Act or not. Many underwater homeowners across the country would benefit if Congress extended the act into 2015 or 2017. But there is no firm indication whether an extension will be forthcoming from our legislators in Washington, D.C., even with bipartisan support.
If Congress does not extend the act, then distressed homeowners in Arizona, Nevada, California, and elsewhere will take yet another financial hit. This time it will be in the form of income tax on canceled loans, restructured mortgages, and short sales.