Forgiven Mortgage Debt May Lead to Huge Tax Bills

by Xin Lu on 26 April 2012 8 comments
Photo: Vinni123

Congress passed the Mortgage Forgiveness Debt Relief Act during the national housing crisis. This little-publicized law protected those who lost their principal residences to a foreclosure or short sale from a big tax bill, and it is expiring at the end of 2012. This means that those who lose their homes or receive a partial loan reduction next year may be facing a huge tax bill. (See also: How Foreclosure, Deed in Lieu, and Short Sale Affect Credit Scores)

Most people are not aware that most debt forgiven by a lender is taxed as ordinary income by the IRS. In the case of a foreclosure or short sale, the lender usually issues a 1099-C to the borrower for the balance still owed, minus whatever the bank sold the house for. Issuing a 1099-C means that the lender will no longer go after the borrower for the loan, and hence, the debt is forgiven or canceled. In cases where homeowners walked away from their houses, it is very easy to get an "income" of thousands of dollars, and the IRS will once again tax that income at the borrowers' highest marginal rates.

For example, suppose that a couple with an annual income of $70,000 owed $500,000 on their loan when their house was foreclosed, and the bank sold their house for $150,000, then they would have a 1099-C with a balance of $350,000. If that foreclosure happened on January 1, 2013, then this couple would have a taxable income of $420,000 for the year 2013 in the eyes of the IRS. This means that this couple would owe over $100,000 to the IRS. To complicate the matter, many states also passed tax laws that conformed to the federal law. So those who have discharged debt on their principal residences in 2013 will also have to pay state income taxes on their loan balance. In California, this would add approximately another $30,000 to this fictional couple's tax bill.

Even if an underwater homeowner manages to get a principal reduction on their loan and keep the house, the loan forgiven will be considered ordinary income starting next year. Not all cancelation of debt is taxable, and you can read about the details of the law. This change will affect those who have money and want to walk away from their loans the most since the IRS will not tax insolvent folks. A person is insolvent if his or her total debt is more than the sum of his or her assets, so those who really have nothing to pay will not be affected.

Since there is no guarantee that Congress will extend this law into 2013 and beyond, if you are underwater on your mortgage, then this year may be the last year to finish up a foreclosure or principal reduction without incurring a tremendous tax bill. For those considering a short sale, it is best to get the process started right now, since it may take many months for a short sale transaction to actually close.

I think the expiration of this law might change the decision-making process of many underwater homeowners if they knew about it.

What do you think? Should this law be extended? If you are underwater on your mortgage, would a potentially huge tax bill prevent you from walking away from your house?

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Guest's picture
Brian

Would they really have a $350 K tax bill on the forgiveness of debt? Wouldnt it be the difference between the loan balance and what the bank sold the house for at auction? So therefore, if the loan was 350k and the house sold at auction for 300K, it would be a taxable income event of only 50K.

Guest's picture
Jian

this is correct catch. The author's point is not correctly considered the IRS only tax net gain on case not whole loan amount because the foreclosed house still have value even it is benign totally diminished because land has value.

Xin Lu's picture
Xin Lu

You're right. They wouldn't have a $350k tax bill. What I meant is that if the bank says that they forgave $350k then they would be taxed on that. I didn't write that they would have a $350 tax bill.

Meg Favreau's picture

Thanks for the catch, guys. The article has been updated!

Guest's picture
Guest

i think forgiveness should be the difference of total loan less the market value of the house which bank have taken to sale.

Guest's picture
Guest

It's probably too late to avoid the tax on a foreclosure in the next 8 months. The lenders cancel the debt several months after the foreclosure has occurred so anything happening in the next 8 months will likely not be canceled until 2013.

Guest's picture

So far there is no indication that the Forgiveness Debt Relief Act will be extended, and if it is not extended, it will be interesting to see how many people receive unexpected notices from the IRS in 2013. Hopefully, real estate agents and other industry professionals will properly advise people of the tax implications of short selling their homes.

Guest's picture
Michael

Forgiven debt = taxable income. Your example in your post was correct. A loan balance of $500k - the $150k sale = $350k of forgiven debt. The lender could choose to 1099 the borrowers (some do - some do not) and they would have to report that as income.