N. Mauricio Reznik's article was featured in the August 2013 issue of Orange County Lawyer Magazine. See the full article originally published below.
The Mortgage Forgiveness Debt Relief Act that was scheduled to expire on December 31, 2012 has been extended until December 31, 2013 thanks to the "fiscal cliff" deal signed by President Obama on January 3, 2013.1 The Mortgage Debt Relief Act brings a much needed sigh of relief to numerous financially distressed homeowners.
Generally, debt that is forgiven or cancelled by a lender must be included as income on your tax returns and is taxable just as earned wages. The Mortgage Forgiveness Debt Relief Act allows a homeowner to exclude certain cancelled debt on his or her principal residence from income. For many struggling homeowners, avoiding this tax equals thousands of dollars saved. The relief benefits homeowners who receive mortgage debt forgiveness as a result of three different types of scenarios: (1) reduction in principal (when the lender reduces the homeowner's monthly payment to prevent foreclosure); (2) foreclosure (the legal process where the lender attempts to collect the balance of the loan by taking possession of the property and selling it); or (3) short sale of the property (when the homeowner sells a house at a price lower than the balance owed on the mortgage of the house).
An example of how this might work would be if a homeowner sells his house in a short sale for $100,000 when he still owes $125,000 on the mortgage loan. The bank forgives the homeowner for the remaining $25,000. In the past, the homeowner would have had to pay income tax on the forgiven $25,000. Under the Mortgage Forgiveness Debt Relief Act, the homeowner is no longer taxed on the forgiven $25,000, resulting in considerable tax savings.
Hence, homeowners burdened by an underwater mortgage or a potential foreclosure ought to consider how the extension of the Mortgage Forgiveness Tax Relief Act can benefit them. However, if this is the right solution for you, you must act quickly because, although the Mortgage Forgiveness Tax Relief Act has been extended twice since its inception in 2007, it is likely to end in December of 2013. Previously, the tax relief law was extended for three years, and on this last occasion it was extended for only one year. There is no guarantee that it will be extended a third time. Thus, if you wish to take advantage of this tax relief, you might need to act quickly. In addition, loan modification or short sale will generally take thirty to ninety days to be completed, while a foreclosure will take at least 110 days. These time factors will need to be considered by any homeowner seeking to take advantage of this relief act. After a foreclosure or short sale, if the amount of debt cancelled is $600 or more, the lender is required to send a form 1099-C--Cancellation of Debt. The amount of debt forgiven or cancelled will be shown in box two of the form. If for any reason homeowner does not agree with the amount deemed cancelled or discharged, he must immediately contact his lender.2
There are five key points that every practitioner should know about the Mortgage Forgiveness Debt Relief Act (3):
- Normally, debt forgiveness results in taxable income. However, under the Mortgage Forgiveness Tax Relief Act, homeowner may be able to exclude up to two million dollars of debt on a principal residence, if filing jointly, or one million if a married person files separately.
- A homeowner may exclude debt reduced through mortgage restructuring, as wells mortgage debt forgiven on the principal residence.
- To qualify, the mortgage must have been used to buy, build, or substantially improve the principal residence, and be secured by that residence.
- Debt forgiven on second homes, rental property, or business property does not qualify for the tax relief provision.
- Proceeds of refinanced debt used for other purposes such as to pay off credit card debt do not qualify for the tax relief provision. There is a certain type of homeowner who could receive meaningful tax benefits from the Mortgage Debt Relief Act. These individuals should act quickly as the process can be time consuming, and the Act is set to expire by the end of 2013.
ENDNOTES (1) The Mortgage Forgiveness Debt Relief Act was introduced in the United States Congress in September of 2007 and became law on December 20, 2007.It originally applied to debts discharged in 2007 through 2009. The Act was extended once more under the Emergency Economic Stabilization Act of 2008 to cover debts discharged through year 2012. (2) The Mortgage Forgiveness Debt Relief Act and Debt Cancellation. IRS. August 3, 2012. (3) Mortgage Debt Forgiveness: 10 Key Points. IRS Tax Tip 2012-39, February 28, 2012.