Tax and Foreclosure

With home ownership being touted as the American Dream, losing a home through foreclosure has to be a nightmare.  As bad as this is, it could be worse.  The way the tax regulations are written, as directed by the Congress and signed by the President, direct the Internal Revenue Service to treat forgiveness of debt as income and this can potentially make it seem like the IRS is kicking someone while they are down.  Fortunately this is no longer the case.

The Facts on Debt Relief

There are many myths about the IRS and before believing one of many urban legends, it helps to check out the IRS website.  In the past and under some circumstances any debt forgiveness is treated as income and the IRS will seek to collect tax on that income.  If the debt forgiveness was significant, this could potentially drive up a taxpayer’s tax rate and thereby add many thousands of dollars to a tax bill.

Thanks to the Mortgage Forgiveness Debt Relief Act of 2007, enacted Dec. 20, 2007 this is no longer the case for those who lose their house to foreclosure and have debt forgiven on the loan by the mortgage holder.  Under the Act, taxpayers may exclude debt forgiven on their principal residence if the balance of their loan was $2 million or less. The limit is $1 million for a married person filing a separate return. Details are on Form 982 and its instructions are available on the IRS web site.

 The Details on Debt Relief and Taxes

Congress saw the pain that the existing tax law was creating and that required the IRS to treat the forgiven debt as income in the midst of a housing price meltdown and took actions to correct the problem with passage of The Mortgage Forgiveness Debt Relief Act.  While the initial Act only applied to mortgage debt forgiven in 2007, 2008 or 2009, subsequent legislation has extended this to 2012.  Any mortgage debt reduced through mortgage restructuring, as well as mortgage debt forgiven via a foreclosure, may qualify for this relief.  In most cases, eligible homeowners only need to fill out a few lines on Form 982 in order to obtain the tax relief.

In order to qualify for the debt relief tax exemption the debt must have been used to buy, build or improve the primary residence of the taxpayer.  If the debt was incurred to refinance only the amount of the previous mortgage principle that was present qualified for the exclusion. Other debts, such as second homes, rental property, business property, credit cards or car loans does not qualify for the new tax-relief provision but if the taxpayer was in an insolvency condition or had declared bankruptcy then the taxpayer may be qualified for relief and exclusion of the forgiven debt from  being counted as income.

Know the Rules and Consult an Expert

Every situation is different and as someone approaches foreclosure or considers bankruptcy it is best to consult a tax expert or a tax lawyer.  Relying on urban legends, the neighbor’s brother or Aunt Sarah for tax advice makes little sense unless they are in fact tax experts.  Get the facts, weigh the options and only then make the best decision for your particular financial situation.