Mortgage Forgiveness Tax Laws

As April 15th has come and past, many of you are probably wondering what are some of the tax ramifications if I pursue a short sale or face a foreclosure. I’m here to answer some of these questions. It is IRS policy to tax forgiven debt you are personally responsible for as if it is income. Say, for example, your credit card company settled a $10,000 debt for 50 cents on the dollar. You’d have a debt forgiveness of $5,000, which the IRS would count as income, just like your wages. That same policy also held true for mortgage debt until Congress passed the Mortgage Forgiveness Debt Act in 2007. This bill ended homeowners liability for mortgage debt but not all of it. There are exceptions to the bill, this is why I’m blogging today.

The first exception is if you did a cash-out refinance and bought unnecessary products i.e.; boats, new cars, vacation homes etc.. Even if your lender agreed to do a short sale and waive your debt the IRS will still count the loss as income. The only type of purchases that are not taxed as income is home improvement. Their reasoning is that money spent on renovations actually added to your homes value, not creating a larger gap between what you owe and what your homes worth.

The next major exception is if you have a home equity line of credit. Same rules apply as a refinance, if you used the money towards home improvements your ok, if not expect a tax hit.

During the boom years buying homes for investment and vacation purposes soared, over 28% of all sales in 2005. When the bubble broke and the economy went sour all these homeowners were left with houses they couldn’t afford. Unfortunately if you didn’t use it as your primary residence for at least 2 out of 5 years the IRS can come after the difference as taxable income.

The group of homeowners that will be facing the heaviest tax bill this year will be the multi-million dollar property owners. IRS policy is only the first $2 million will count as forgiven debt, the rest all taxable income. Lets take Nicholas Cage for example, we all have heard is financial troubles over the past year. He bought a house in Hollywood for close to $8 million, did a short sale for $4 million. IRS will cover the first $2 million, therefore showing this actor made $2 million as taxable income.

Ryan Nager is an agent specializing in Mesa Real Estate and a Short Sale Agent