Tax Break For Distressed Homeowners Is Scheduled To Expire
Federal tax law generally requires that a taxpayer who has indebtedness that is forgiven by a lender is required to claim and pay taxes on the amount of the forgiven indebtedness, which is classified as “income”. As a result, prior to 2007 homeowners whose homes were foreclosed upon or who completed short sale transactions (or received principal reductions in loan modifications) were potentially required to pay taxes on the amount of indebtedness which was forgiven in those transactions. The Mortgage Forgiveness Debt Relief Act of 2007 was passed by Congress in order to modify the law by providing taxpayers who met certain requirements an exemption from taxation on the forgiven indebtedness. That law, however, is scheduled to expire at the end of 2012 and, unless extended by Congress, will result in the loss of this exemption and the imposition of additional and potentially significant taxes on thousands of distressed homeowners.
More than 50,000 homeowners go through foreclosure each month and the number of short sales has increased significantly over the last few years to approximately 500,000 per year. In addition, as a result of the $25 billion foreclosure irregularity settlement which the nation’s largest mortgage lenders recently entered into with the federal government, thousands of homeowners may receive principal debt reductions over the next few years. Although an extension of the exemption would seem to be a “no brainer”, the fact that Congress is entering a “lame-duck” session creates the possibility that little legislation will move ahead through the end of the year.
Even if the law does expire, some homeowners will still be eligible to exclude the income from forgiven indebtedness. For example, if the debt is discharged in bankruptcy or the homeowner is “insolvent” (meaning they have more debt than assets) at the time of the debt forgiveness, no tax is due. But homeowners who are considering a short sale and their agents should take this pending expiration into account and seek competent legal or tax advice so they will be prepared for the ramifications to them, if any, that will result if the law is not extended by Congress prior to the end of the year.