Normally, when you receive any reduction in the amount of debt you owe someone it is a taxable event. For example, if you owe someone $10,000 and the lender forgives $5,000 of that debt, that $5,000 is consider income and you have to pay tax on that amount. Under the Mortgage Forgiveness Debt Relief Act of 2007, taxpayers are allowed to exclude from their income the discharge of debt for their primary residence. This exclusion expires on December 31, 2012, unless extended by Congress.
This could pose some problems for homeowners who are underwater and/or struggling to pay their mortgage. There are only 11 months left to benefit from this tax break. Banks are currently backed up and it could tax more than 11 months to resolve issues for financially troubled homeowners. According to Lender Processing Services in Jacksonville, Florida, as of October 2011 it was taking lenders on average 674 days (22 months) to process a foreclosure. They also stated that it takes lenders on average 391 days after receiving the borrowers’ last payment to get the process started.
If you, or your clients, are facing financial problems with a mortgage on a primary residence, now is the time to start getting the process rolling if you are planning on (i) obtaining debt forgiveness, (ii) conducting a short sale, or (iii) deciding to walk away from the home in a foreclosure process to avoid any tax consequences.
Some other facts to consider include:
- The Mortgage Forgiveness Debt Relief Act of 2007 applies to debt incurred to buy, build or improve a primary residence
- Investment properties and vacation homes are not eligible for the exclusion
- The maximum amount of the exclusion is $2 million, $1 million if married filing separately