Foreclosures, Debt Forgiveness Could be Taxed Again Beginning January 1
Financially strapped homeowners stand to become even more downtrodden in 2013. As Congress focuses on the upcoming federal elections, a little-known or -understood law is scheduled to reappear, potentially costing those in foreclosure or loan modification thousands of dollars in new tax liabilities.
"There is a very dark cloud on the horizon that will be devastating to those facing foreclosure or even a short sale or loan modification," said James L. Paris, founder and editor-in-chief of Christian Money.com.
Paris notes that in 2007 Congress passed into law the “Mortgage Forgiveness Debt Relief Act," which forgave taxes that normally would be owed when a home is foreclosed, short-sold, or a loan is modified. The protections of this law disappear on January 1, 2013, leaving millions of homeowners in a very precarious situation.
Foreclosures Had Been Taxed
Bankruptcy historically has not been taxed, but foreclosures have been.
“Historically, the way the tax code deals with bad debts is to allow the creditor to write off the debt and require the debtor to declare the forgiven debt as income,” said Paris. “A major exception to this is bankruptcy. A debtor can discharge their debts in bankruptcy without any tax consequences in most cases. In fact, this is one of the major reasons that people file for bankruptcy.
“The Congress assessed the landscape of America's economy and real estate crisis and decided to forgive the tax consequences of those that lost their home to foreclosure,” Paris added. “The provision was written to also forgive the tax consequences associated with a short sale or loan modification as well.”
Paris explains the consequences by saying, “So, on the one hand the lenders were allowed to take their write-offs, but the government would not require the debtor to face any tax consequences. This applied only to principal residences and was a great move that likely kept millions out of bankruptcy. The 2007 Act was never meant to be a long-term part of the tax code and is set to expire at the end of 2012.”
Paris gave the following example: Consider $50,000 of debt forgiveness added as income to your tax return and what that would do. Not only would you owe income taxes on this money, but it likely would kick you into a higher tax bracket, raising the marginal tax rate that would apply to the income you earn from your employment.
Election Could Delay Action
Paris said he doubts Congress will extend the tax moratorium on foreclosures before it expires, but he thinks Congress might take action in 2013.
“It is unlikely that Congress will take any action on this due to the upcoming election,” he said. “The most that can be realistically hoped for is that the new Congress will enact a retroactive measure early in 2013. This may or may not happen, and individuals that follow tax legislation closely are split on their expectation of an extension of the 2007 Act.”
Paris said if persons find themselves in foreclosure or needing to complete a short sale or loan modification, they should grab a calendar and circle December 31 in red. These tasks can take months to complete. To be safe, said Paris, people need to do everything they can to make the forgiven debt stay within 2012.
John W. Skorburg (firstname.lastname@example.org) is associate editor of Budget & Tax News and a lecturer in economics at the University of Illinois at Chicago.
From the IRS Web site—
“If you owe a debt to someone and they cancel or forgive that debt, the canceled amount is usually taxable, as income on your tax return. Following a foreclosure, short sale or loan modification, a lender forgiving a portion of your debt issues a 1099 in the amount of the forgiven debt.
“The Mortgage Debt Relief Act of 2007 allows taxpayers to exclude income from the forgiveness of debt on their principal residence.”