Bankruptcy may be more necessary than you think. You have lost your home to foreclosure. Surprise, here is the bill for the income tax you now owe. Maybe not, if you are one of the former homeowners saved from grief by federal legislation. On December 20, 2007, the Mortgage Forgiveness Debt Relief Act of 2007 became law. This law will protect some but not all foreclosed homeowners from a one-two gut punch. While it has received some press from time to time, it is still not commonly known that a tax liability is created when debt is forgiven in a home foreclosure. This can be a nasty second hit for a recently dispossessed family.
Congress and the President apparently expect many taxpayers to lose their homes over the period the law covers. Our government may now avoid some of the outrage these down-and-out voters would have felt if they were hit with a tax liability in addition to losing their homes.
Before this piece of legislation, cancellation of debt from foreclosure or short sale (sale of a home for less than the amount owed) generally resulted in additional tax liability based on the difference between what the home was sold for and the amount of the total debt. Unfortunately, many foreclosed homeowners may not be protected by this law.
The relief from debt stemming from foreclosure of a personal residence, but only to the extent the debt went into buying or improving the house, will now be left out of taxable income if a foreclosure occurs between January 1, 2007, and December 31, 2013. However, many will still feel the sting of this tax viper unless they file a petition in bankruptcy.
The limit on cancellation of debt a homeowner can claim before it becomes taxable appears to be generous. The limits are $2,000,000 or $1,000,000 for a married taxpayer filing a separate return. Nonetheless, many consumers will still get hit with a tax bill after the foreclosure of their real estate loans. The first big problem will be that only debt from buying or improving the property is covered by the new law. When home values were skyrocketing and sub-prime lenders were handing out money like candy on Halloween, it was quite popular for the debt burdened middleclass consumer to take out a second mortgage or home equity line of credit to consolidate high interest credit card debt. Few will have refinanced their homes without paying off outstanding consumer debt. In many cases, it would have been a requirement of the lender. This portion of the home debt will continue to trigger tax liability when the loan is foreclosed.
Second homes, vacation homes, business and investment property are not included in the forgiveness; it will only apply to debt secured against the qualified principal residence of the taxpayer. If a taxpayer has two homes, only the home that is used the majority of the time will qualify in most circumstances.
When calculating the amount of forgiven debt that is covered by this statutory exclusion, any debt not used to buy or improve the principal residence will continue to be considered as income to the foreclosed homeowner. This means that a careful analysis of the loan history and actual expenditures made by a debtor must be made before a foreclosure is permitted. Unfortunately, a byproduct of this legislation could well be a false sense of security for a homeowner facing foreclosure. The failure to act promptly could result in the unfortunate gut punch described above with tax liability on top of loss of the home.
The bankruptcy and insolvency exceptions to cancellation of debt income taxation still are available. However, the taxpayer must be insolvent at the time of the foreclosure, or the foreclosure must occur after or during the bankruptcy to qualify for these exclusions. If a bankruptcy is filed too late or the taxpayer has retirement funds or other assets at the time of foreclosure, there can still be an enormous and unexpected tax liability resulting from the foreclosure.
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Last modified: March 5, 2013