The Fuse is Burning and Time is of the Essence — The Pending Expiration of the Mortgage Forgiveness Debt Relief Act

The clock is ticking for individuals either facing foreclosure or that are underwater and desire to complete a short sale of their primary dwelling, in regards to any debt forgiveness.  What may not be a taxable event in 2012, might become imputed ordinary income in 2013 (assuming Congress does not extend some previous legislation).  If you are contemplating either completing a short sale or being foreclosed on, make certain to have these completed by year end or you will potentially owe ordinary income tax in 2013 on the same transaction.  Time is quickly expiring.

When you owe a debt to someone and the obligation to repay that debt is either canceled or forgiven, you may owe standard income tax on that amount—i.e. the forgiven debt is considered imputed ordinary income by the IRS in most circumstance.  One of several exceptions, at least from January 1, 2007 through December 31, 2012, is debt forgiven on your primary dwelling–an exclusion created by the Mortgage Forgiveness Debt Relief Act (The Act). 

When a debt repayment is canceled, the lender in most circumstances is required to report that amount to the borrower and the IRS—with the borrower receiving a From 1099-C (cancelation of debt).

In late 2007, Congress passed The Act, which details the following circumstances under which no income tax liabilities may be due for debt relief on your primary dwelling:

  • Debt must have been used to buy, build or improve your primary dwelling, or the debt could also be a refinance of the prior.  If the debt was a cash-out refinance not used to improve or purchase the property, it would not qualify under The Act
  • The debt must be forgiven between January 1, 2007 and December 31, 2012
  • Only primary dwellings qualify—not second homes, cars, credit cards, student debt…..
  • A married couple filing jointly can qualify for up to $2 million of debt forgiveness on their primary dwelling while a single person or a married person filing separately qualifies for up to $1 million at the time the loan was forgiven
  • Even though the debt is forgiven, the tax payer must report that amount on IRS Form 982 (completing just lines 1e and 2)

An Example

A primary dwelling was purchased at the peak of the market in 2007, and a $200,000 loan taken out.  In addition, the homeowner(s) borrowed $25,000 for a new swimming pool.  The home is now worth $125,000 (and for simplicity assume the total debt outstanding is still $225,000).   If the owner(s) complete a short sale or a foreclosure takes place  in 2012 and the debt is forgiven, then they owe no tax liability on the $100,000 of debt forgiven.  If, however, the same transaction was delayed until 2013 (and assuming Congress does not extend The Act), then the owner(s) would have an imputed $100,000 of ordinary income, and assuming they were in the 20 percent tax bracket, then they owe an added $20,000 of income taxes. 

If in addition to the two loans mentioned above, the homeowner(s) also had an Home Equity Line of Credit which was used to pay for a car, vacations  or credit card debt, would that also not be taxable?  No—such debt forgiveness would be taxable since it was not used to either acquire or improve the primary dwelling.

Are there other instances when debt forgiveness is not taxable?  Yes—and details for both The Act and debt forgiveness in general are available from the IRS.

Time is of the essence for struggling underwater homeowners.  Always consult expert tax counsel on your individual specifics and potential tax implications.

Ted

Comments

  1. denny

    We did the same thing bought the house in 2007 took money out of our down payment and put a pool in. We are going through a short sale. My wife and I are in the Air Force and are moving to Japan. Is the money i used for the pool considered “improving” the house so that loan would be non taxable?

    1. Ted C. Jones Post author

      First—we both agree we have never communicated prior to this so the blog was not about your specific issues. I believe the money used to put in the pool qualifies under improvements under The Act. So I would assume that forgiveness of debt would be both for the purchase and improvements. But be certain to talk to your tax specialist including all details. Just be certain to close this transaction prior to midnight December 31, 2012.

      And thank you for your service Sir. You allow me and others our freedom.

      Ted

  2. Diva

    i like to come to your website everyday to see what’s new.

  3. Ray E. Robinson

    Bought an income property in 2005 for $575,000, using approximately $175,000. It sold in 2011 for $208,000. How do I report the $175,000 I loss and is there an ‘off-set’ on the amount the bank will be reporting to the IRS.

    Thanks,

    Ray

    1. Ted C. Jones Post author

      You need the help of a qualified tax-specialist (which I am not). Perhaps your CPA can help on this.

      Ted

  4. Ray E. Robinson

    Bought an income property in 2005 for $575,000, using approximately $175,000. It sold in 2011 for $208,000. How do I report the $175,000 I loss and is there an ‘off-set’ on the amount the bank will be reporting to the IRS.

    Thanks,

    Ray

    1. Ted C. Jones Post author

      You need the help of a qualified tax-specialist (which I am not). Perhaps your CPA can help on this.

      Ted

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