Mortgage Forgiveness Debt Relief Act – What It Means For You
Thanks to Steve Beck, Esq. for his excellent commentary on our recent blog post: Short Sales and Deeds in Lieu of Foreclosure (on March 12th). In response to the article, Mr. Beck wrote:
“[T]he Mortgage Forgiveness Debt Relief Act of 2007 was extended to 2012, which allows homeowners whose debt was cancelled by their lender on a principal residence to avoid tax liability from the resulting debt cancellation. See this IRS link for more details.”
NO TAX LIABILITY FOR SOME LOANS SECURED BY YOUR PRIMARY HOME
In the past, homeowners using short sales or deeds in lieu of foreclosure were required to pay tax on the amount of their forgiven debt. However, the new Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) changes this for certain loans. And, as Mr. Beck mentioned, the Act has been extended to 2012!
The new law provides tax relief if your deficiency stems from the sale of your primary residence, or the home that you actually live in. Ski condos, for example, do not qualify. Here is an overview of the rules:
- Loans for your primary residence. If the loan was secured by your primary residence and was used to buy or improve that house, you may generally exclude up to $2 million in forgiven debt. This means you don’t have to pay tax on the deficiency.
- Loans on other real estate. If you default on a mortgage that’s secured by property that isn’t your primary residence (for example, a loan on your vacation home), then you’ll owe tax on any deficiency.
- Loans secured by but not used to improve primary residence. If you take out a loan, secured by your primary residence, but use it to take a vacation or send your child to college, you will owe tax on any deficiency.
The insolvency exception to tax liability. If you don’t qualify for an exception under the Mortgage Forgiveness Debt Relief Act, you might still qualify for tax relief. If you can prove you were “legally insolvent” at the time of the short sale, you won’t be liable for paying tax on the deficiency.
Legal insolvency occurs when your total debts are greater than the value of your total assets (your assets are the equity in your real estate and personal property). To use the insolvency exclusion, you’ll have to prove to the satisfaction of the IRS that your debts exceeded the value of your assets.
Bankruptcy to avoid tax liability. In Colorado, you may also be able to get rid of this kind of tax liability by filing for Chapter 7 or Chapter 13 bankruptcy, if you file before escrow closes. Of course, if you are going to file for bankruptcy anyway, there isn’t much point in doing the short sale or deed in lieu of foreclosure, because any benefit to your credit rating created by the short sale will be offset by the bankruptcy.