One of the more frequent questions asked by a homeowner considering a short sale to cure foreclosure is whether the homeowner will be taxed on this forgiveness.
Some background: Typically a short sale occurs when the property is no longer worth the amount that the lender is suing you in foreclosure for. (ie. you are being sued for $300,000 and your home is only currently worth $150,000). In this case, you wish to sell the property and think you can do so for around $150,000. You, or your lawyer, will be asking the bank for forgiveness off the debt above the $150,000 in our example, thus releasing you from any money liability to your lender and “walking away clean.”
But there is an issue with this. What happens to that forgiveness in terms of your taxes? Usually, forgiveness of any type of debt is considered income to you, and thus taxable. In our example above, the homeowner would be liable for taxes on $150,000 in extra income. This means if you make a yearly salary of $50,000, next year you would be taxed on $200,000 in total income, and at a much higher tax bracket.
The Mortgage Forgiveness Debt Relief Act of 2007 was made to address this issue Act stated that in the case of debt forgiveness for a primary residence, this income would NOT be taxable. thus, in our example above, the $150,000 would to be taxable and would vanish “into thin air.” In the case of a foreclosure, there can be circumstances under which a mortgage debt is forgiven (the debt not fully paid by the recovery of the home in foreclosure), and a homeowner then “charged” with additional, taxable income. As a result of the flood of foreclosures in 2007, a law was passed which provided that under certain limited circumstances, that forgiveness certain related debt would not be considered taxable as income to the homeowner.
This Act led to a surge in short sales, and short sales have tripled in the past 2 years. Short sales have also spiked in recent months. The National Association of Realtors reports that “Short sales from borrowers behind on their payments jumped 22 percent over last year for the three months ending Sept. 30, RealtyTrac reports. Short sales also jumped 17 percent among borrowers who were still current on their payments.” Why?
The Act was set to expire but, in a last minute deal struck by Congress, a key provision protecting borrowers losing their homes was extended for one more year. The Mortgage Forgiveness Debt Relief Act of 2007, which technically expired on December 31, 2012 was extended to December 31, 2013.
Short sales would have come to a halt as no reasonable homeowner would have wanted to pay the taxes on 6 figures of extra income next year. Theoretically, this would have greatly slowed the housing recovery as homeowners would have been much more hesitant to sell rather than just stay in their property as long as possible until the bank forced them out. Foreclosures would have clogged up the courts more than they already are because people would have chosen to fight instead of trying to work something out with the banks. There would have also likely been a large spike in Chapter 7 bankruptcy filings because you can eliminate all of the mortgage debt (and tax liability) in a bankruptcy.
Luckily for homeowners, there is one more year of debt forgiveness. After December 31, 2013, it is likely that there will be another similar crisis for homeowners left with properties with properties valued at much less than the mortgages on them.