Is a short sale or foreclosure in your future?
Taking a hit on your credit is bad enough, but did you know that you might pay income tax on the bank’s loss?
The Mortgage Forgiveness Debt Relief Act (HR3648) is set to expire at the end of 2012. For short sellers of their primary residences, this act provides tax relief if they close in 2012.
If you undertake a short sale, deed-in-lieu or foreclosure, then you may be taxed on the lender’s loss. If the lender must write off $100,000 for example, then you will receive a Form 1099-C at the start of the year showing that the bank forgave $100,000 of debt – which counts as income to you (see my blog post: Short Sales – Report the income & exemption).
Prior to the Mortgage Forgiveness Debt Relief Act (HR3648) in 2008, homeowners of primary residences were subject to a “Phantom Tax” whereby the amount forgiven would count as income. Since the passage of HR3648, eligible homeowners still report the canceled debt as income, but they also are granted exclusion to write off the income. The write off only applies to forgiven debt on primary residences and canceled debt up to $2,000,000. If you acquired a home equity line of credit (HELOC) after closing that was not used to improve the property, then forgiveness of that loan may be subject to tax.
Bottom line: Tampa Bay homeowners considering a short sale should act now. A short sale may take 3-10 months to complete, and you must close prior to the end of 2012. There is no guarantee that the Mortgage Forgiveness Debt Relief Act (HR3648) will be extended. Please consult a qualified tax professional for details. Below is information from the IRS web site which addresses some of the questions on this law:
IRS Tax Tip 2011-44, March 3, 2011
If you are a homeowner whose mortgage debt is partly or entirely forgiven during tax years 2007 through 2012, you may be able to claim special tax relief and exclude the debt forgiven from your income.
Here are 10 facts the IRS wants you to know about Mortgage Debt Forgiveness.
1. Normally, debt forgiveness results in taxable income. However, under the Mortgage Forgiveness Debt Relief Act of 2007, you may be able to exclude up to $2 million of debt forgiven on your principal residence.
2. The limit is $1 million for a married person filing a separate return.
3. You may exclude debt reduced through mortgage restructuring, as well as mortgage debt forgiven in a foreclosure.
4. To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence.
5. Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion.
6. Proceeds of refinanced debt used for other purposes – for example, to pay off credit card debt – do not qualify for the exclusion.
7. If you qualify, claim the special exclusion by filling out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attach it to your federal income tax return for the tax year in which the qualified debt was forgiven.
8. Debt forgiven on second homes, rental property, business property, credit cards or car loans do not qualify for the tax relief provision. In some cases, however, other tax relief provisions – such as insolvency – may be applicable. IRS Form 982 provides more details about these provisions.
9. If your debt is reduced or eliminated you normally will receive a year-end statement, Form 1099-C, Cancellation of Debt, from your lender. By law, this form must show the amount of debt forgiven and the fair market value of any property foreclosed.
10. Examine the Form 1099-C carefully. Notify the lender immediately if any of the information shown is incorrect. You should pay particular attention to the amount of debt forgiven in Box 2 as well as the value listed for your home in Box 7.
For more information about the Mortgage Forgiveness Debt Relief Act of 2007, visit http://www.irs.gov. A good resource is IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments.
You can also use the Interactive Tax Assistant available on the IRS website to determine if the cancellation of debt is taxable. The ITA tool is a tax law resource that takes you through a series of questions and provides you with responses to tax law questions
Taxpayers may obtain copies of IRS publications and forms either by downloading them from http://www.irs.gov or by calling 800-TAX-FORM (800-829-3676).
Links: IRS Form 982, IRS Form 1099-C, Publication 4681