Taxation of Mortgage Debt Forgiveness

Are you short selling your house? Or do you expect your house to go through a foreclosure? Either way, you need to consider the income tax consequences.

When you short sell your house you are selling your house for less than the amount you owe on the house. For example, let’s assume you sell your house for $300,000 but you owe $350,000 on your mortgage. Since the bank receives $50,000 less than it is owed it is considered a short sale. This $50,000 the bank didn’t get paid is called a “deficiency.”
Usually, in a short sale, the holder of the mortgage agrees that you will not have to pay the $50,000 deficiency. The $50,000 deficiency is said to be “forgiven”. But even if the bank does not forgive the deficiency the California Legislature passed a law (CCP 580e) that says you are automatically forgiven on first mortgages as long as the property in question is 4 units or less.

But here’s the problem: In general forgiven debt is considered income for income tax purposes. After this short sale, the lender will probably send you and the IRS a 1099_C reporting $50,000 of income to you. You would probably consider it to be a disaster if you had to pay taxes on this $50,000 of forgiven debt.

The U.S. Congress was concerned with this problem and in 2007 it passed the Mortgage Forgiveness Debt Relief Act of 2007. If this act applies to your situation, the debt forgiveness will not be counted as income. Here are the requirements:

1. You can only exclude up to $2 million of debt forgiven and it must be on your principal residence.
2. The limit is $1 million for a married person filing a separate return.
3. To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence.
4. Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion.
5. Proceeds of refinanced debt used for other purposes – for example, to pay off credit card debt – do not qualify for the exclusion. In other words, if, when you took out that mortgage you used, say 10% of the money to pay off some credit cards, then 10% of the forgiven debt would be considered taxable income (unless there is some other exclusion)
6. Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the tax relief provision.

But what about debt forgiveness that doesn’t qualify for the Mortgage Forgiveness Debt Relief Act of 2007? What about mortgage debt that was incurred for the payment of credit cards? What if the mortgage debt was for a vacation home?
There is another tax rule that says that if you were insolvent when the debt forgiveness occurs then you will not be considered to have received income to the extent you were insolvent. In this context “insolvent” means that you owned less in assets than you had in liabilities.

The income from debt forgiveness issue is also present in the case of foreclosures.
Let’s assume you have just a first mortgage (no second) on your home. You, like a lot of people, are under water. The home is worth $300,000 but the balance on the mortgage is $350,000. Now let’s assume the bank forecloses. Since you owe $350,000 but the bank is only getting a home worth $300,000 the bank isn’t getting the loan fully paid off. It is being shorted $50,000. That $50,000 is a deficiency.

Under California law (CCP 580d) the deficiency is automatically forgiven if the foreclosure was a non-judicial foreclosure. Banks almost always use this method. So again we have $50,000 of forgiven debt. The forgiven debt is considered taxable income unless there is a rule exempting it from taxation.
Fortunately the Mortgage Forgiveness Debt Relief Act of 2007 is applicable to foreclosed mortgages in the same way as it is applicable to short sales. Therefore as long as the debt was to purchase or improve your primary residence you won’t be taxed on the debt relief up to the maximum limit.

But what if the debt doesn’t qualify for the Mortgage Forgiveness Debt Relief Act of 2007, maybe because some of the money was used to pay credit card debt. Again, if you are insolvent when the foreclosure occurs there is no taxable income resulting from the debt forgiveness.
Now let’s assume that when the bank that held the first mortgage foreclosed there was also a second mortgage on the property. When you go through a foreclosure and you have a second on your property the second may or may not be forgiven as a result of the foreclosure. It depends on the purpose of the second.
If the second was taken out to purchase the property and its residential property of 4 units or less then it is forgiven automatically under CCP 580b. It is not forgiven if the second was taken out for any other purpose, e.g. to pay credit cards, improve the property, to refinance another loan.

So if you had purchase money second on the residential property when you went through foreclosure it will be forgiven. The Mortgage Forgiveness Debt Relief Act of 2007 will exclude the income if the second was taken out to purchase your principal residence. But if the second was taken out to purchase residential property that wasn’t your principal residence (e.g a vacation home or rental property) the deficiency is forgiven under CCP 580b but the income is not exempt from taxation under The Mortgage Forgiveness Debt Relief Act of 2007 since it was not your personal residence.

If the second mortgage was not a purchase money loan then it will not be forgiven and you will not be taxed. But you will still owe the full amount of the second mortgage and that bank will probably sue you. You might need to declare bankruptcy.

If you settle with the bank that holds the second mortgage, say for fifty cents on the dollar then you will have debt forgiveness income in the amount the lender forgave. If that loan meets the requirements of The Mortgage Forgiveness Debt Relief Act of 2007 or if you are insolvent then you won’t be taxed on the amount of the debt forgiveness.

Let’s say you expect to have some debt forgiveness income. Perhaps because you plan to have a short sale or foreclosure on a mortgage that was not entirely purchased money and you are solvent. Debt forgiveness caused by bankruptcy is exempt from taxation. So if you file for bankruptcy before the event causing the debt forgiveness occurs (e.g. foreclosure) then you will not be taxed on the debt forgiveness income. That is because the debt forgiveness will be deemed to have occurred as a result of the bankruptcy.

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