As I’m sure you were aware, yesterday was tax day. You may be less aware that the expiration of a tax relief act at the end of 2012 could have negative ramifications for distressed homeowners conducting short sales.
In some circumstances, the IRS classifies forgiven debt as income, which is taxable in the same way as any other income. The Mortgage Debt Forgiveness Act was passed in 2007 in order to give struggling homeowners relief from tax burdens that can be associated with debt forgiveness resulting from foreclosures and short sales.
Let’s take a look at a hypothetical example to illustrate how the Mortgage Debt Forgiveness Act could impact someone conducting a short sale. Say our fictional homeowner owes $200,000 on their mortgage, but their home is only worth $150,000 due to declining home values. The homeowner gets approval to sell the home for $150,000 and their lender forgives the remaining $50,000 that is owed on the mortgage. In some circumstances, this $50,000 is classified as taxable income, and come tax time, the homeowner would owe taxes on that income. As a result of the Mortgage Debt Forgiveness Act, the tax on this forgiven debt is eliminated.
Here’s the rub: the Mortgage Debt Forgiveness Act is due to expire at the end of 2012. This means that a lot of people conducting short sales could end up with additional tax liabilities if they complete their sale after the end of year (barring an extension of the act by Congress).
This January short sales surpassed foreclosure sales for the first time, according to data from Lender Processing Services. This is a good thing as short sales are almost always preferable to foreclosures. A short sale ends up costing the lender less than a foreclosure, short sales have a less detrimental impact on the borrower’s credit than a foreclosure does, and short sales have less negative externalities associated with them than foreclosures. Short sales should be encouraged, and the Mortgage Debt Forgiveness Act should be extended in an effort to help pave the way for more short sales.
It is worth noting that forgiven debt is not always classified as income (there are a variety of examples of this on the IRS’ website). One of the biggest factors is whether or not your state is a recourse or non-recourse state. On a non-recourse loan, the lender’s remedy in the event of default is to repossess the property, on recourse loans, the lender may sue the borrower for the amount they are deficient and possibly seize their assets to make up for the shortfall. Whether or not a mortgage is a recourse or non-recourse loan varies from state to state.
Please note that I am not a tax lawyer or CPA, and I strongly advise you to consult a tax professional to see how the Mortgage Debt Forgiveness Act applies to your situation. Taking tax advice from people on the internet is generally not advisable.