There are many supplemental issues that arise in the case of a foreclosure. One of these issues has to do with taxes. First of all, loans are not considered taxable income because it is assumed that they will be paid back. As you may suspect, the game changes when the loan is forgiven before the payback is made.
Ordinarily in cases where a lender forgives debt on a mortgage, or any other loan, the IRS requires you to claim that debt on your taxes by filing a Form 1099-C, Cancellation of Debt, to report the amount forgiven. This presented a very unfortunate situation for distressed homeowners who had just lost their homes and then were expected to pay tax on the mortgage amount that they were forced to walk away from.
However, congress passed the Mortgage Forgiveness Debt Relief Act of 2007, which eliminates the taxes for many homeowners in this situation. But you must know how the law works to take advantage.
However, congress passed the Mortgage Forgiveness Debt Relief Act of 2007, which eliminates the taxes for many homeowners in this situation. But you must know how the law works to take advantage.
For example, the forgiven debt must have been used to purchase, improve, or build a new primary residence. (Secondary residences do not qualify.) In addition, the act only covers debt forgiven from 2007 to 2012. That means it's important to act before the legislation sunsets in 2012.
Additionally, homeowners who refinanced and used the forgiven debt to pay off other commitments, such as student loans or credit card bills do not qualify for the tax exclusion do not qualify, because they are still considered having benefitted from the forgiven loan amount.
People that do qualify under the act can exclude up to $2 million in forgiven debt, even if the debt is spread out over several years. If you are married but filing your taxes separately, you and your spouse can each exempt $1 million of the forgiven debt.
Mortgage debt forgiven through short sales can also qualify for the program. However, homeowners considering a short sale need to be conscious of how long so-called 'short' sales typically take. If you wait too long, the short sale may not be completed within the allotted time period under the Mortgage Forgiveness Debt Relief Act.
Source: The Washington Post, "For homeowners in trouble, a tough decision to make," Michelle Singletary, Sept. 24, 2011.
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