2007 Mortgage Forgiveness Debt Relief Act- A Closing Window Of Opportunity in 2012
As someone who specializes in Phoenix short sales, I wanted to take a moment to discuss what I feel will be the "800-pound gorilla" for distressed homeowners in 2012...The expiration of the 2007 Mortgage Forgiveness Debt Relief Act on December 31, 2012.
First, I need to disclose to you that I am not a CPA, and I highly recommend that anyone looking for in-depth information on this topic visit with a CPA and/or a qualified tax attorney. My intent here is to simply summarize the details of this important legislation, and wrap up with my thoughts on the importance of it to distressed homeowners.
So, what is the 2007 Mortgage Forgiveness Debt Relief Act?
Per the IRS.gov website, "The Mortgage Debt Relief Act of 2007 was enacted on December 20, 2007. Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence". Let me give you a very simplified example. You borrow $200,000 and either default on the loan (foreclosure) or short sell the home for $100,000. In the case of the foreclosure, we'll assume that the lender sold the home at auction for $100,000 as well. In either case, if the lender is not able to collect the remaining debt from you, there is a cancellation of debt of $100,000, which would otherwise be taxable to you, the borrower.
Is Cancellation of Debt Income always taxable?
No, there are exceptions. Here are some of the most common situations where the cancellation of debt income IS NOT taxable. The following was taken directly from the IRS.gov website:
- Qualified Principal Residence Indebtedness- The home must be your "primary residence" in order to qualify for the 2007 Mortgage Forgiveness Debt Relief Act.
- Bankruptcy- Debts discharged through bankruptcy are not considered taxable income.
- Insolvency- If you are insolvent at the time of the debt cancellation, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets, according to the IRS.
- Certain Farm Debts- If you inccured the debt directly in the operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.
- Non-Recourse Loans- A non-recourse loan is a loan for which the lender's only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences. HELOC's (Home Equity Line of Credit") are generally NOT considered eligible for the Mortgage Debt Relief Act.
You can learn more about these exceptions by reading Publication 4681.
What does exclusion of income mean?
Normally, debt that is forgiven or cancelled by the lender is considered to be income to the IRS, and should be included on your personal tax return. The Mortgage Forgiveness Debt Relief Act allows you to exclude certain cancelled debt on your principal residence from income. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.
Does the Mortgage Forgiveness Debt Relief Act apply to all forgiven or cancelled debts?
No. According to the IRS, the Act only applies to "forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. This is known as qualified principal residence indebtedness, and the maximum amount you can treat as qualified principal residence indebtedness is $2 Million or $1 Million if married filing separately". We have had cases whereby our client took out a HELOC in order to pay for improving the home. In these cases, their debt qualified for the Act, and they were not forced to pay taxes for the deficiency. Again, each case is different, and only a CPA can give you direction on this issue.
Does The Mortgage Forgiveness Debt Relief Act apply to debt incurred to refinance a home?
The debt qualified, but only to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified. This question often comes up with our clients that have refinanced at some point. The main problem that comes up is for those borrowers who chose to conduct a "cash-out" refinance. Generally speaking, any cash that is taken above and beyond the original loan amount is considered taxable in the case of a foreclosure or short sale, unless the funds were used to substantially improve the property. Again, consult with your CPA for more direction on this common situation.
If the forgiven debt is excluded from my income, do I have to report it on my tax return?
Yes. It must be reported on Form 982 and this form must be attached to your tax return.
How long is the Act in effect?
The Mortgage Forgiveness Debt Relief Act expires on December 31, 2012. At this point, I am not aware of any talk in our government in regards to extending it past this date. My hope is that the National Association of Realtors will ramp up their efforts in 2012 to push for it's extension.
Obviously, there are many, many more questions that you may have in regards to your particular situation. Again, I strongly recommend that you contact a CPA that is familiar with this Act, and ask him/her how it relates to your current predicament.
So, what's the big deal if the Mortgage Forgiveness Debt Relief Act isn't extended?
If you or someone you know is contemplating a foreclosure or short sale in 2012, I strongly recommend that you consider your options early in 2012. If this Act isn't extended, borrowers who choose to mitigate their losses in 2013 stand to not only lose their home, but could face a HUGE financial hit by having to pay income taxes on their cancelled debt. Please remember that a short sale can take 4-6 months to complete, making it critical to start the process early in 2012. Those borrowers who choose to start the process in June or July are running the risk of their home closing escrow in 2013, which makes all of their efforts a moot point.
Bank lobbyists will be pushing to have this legislation end on it's intended date of December 31, 2012. By allowing it to end, lenders will be given yet another stick to beat borrowers over the head with, and they will be using it to their full advantage during the 2nd half of 2012. I can hear it now..."Make your payments, or we will foreclose in 2013, and you will be responsible for paying income tax on your deficiency".
This critical piece of legislation has saved distressed homeowners un-told millions of dollars since it's passage in 2007. Those that act early in 2012 will be happy they did. Those that procrastinate to squeeze out a few more months of "free-living" will wake up in 2013 and wished they had heeded the advice of their experienced short sale agent and/or CPA.
If you're a short sale agent, do your part to spread the word. If you're a homeowner that wants to learn more about the short sale process, visit our Phoenix short sale FAQ's page, or feel free to contact me directly.
Until next time...
Summit Home Consultants
Copyright © By Bob Hertzog 2011 *2007 Mortgage Forgiveness Debt Relief Act-A Closing Window Of Opportunity in 2012*
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