Short-Sales and Foreclosures – The Bank Might Not Make You Pay, But Don’t Forget About Uncle Sam!

Considering the current Real Estate downturn, there is a pretty good chance that some who read this blog are in the process of losing their homes. Hopefully the percentage of readers in this situation is smaller than the national average because you have learned to budget well. Even if you are not in this situation, there is a really good chance that you know someone who is and, if so, this article may help them know what to expect from a tax standpoint.

The Way it Normally Works

The IRS looks at all debt that is reduced or forgiven in one way – as taxable income! Why? Because then they can tax it! No, it actually makes sense. If you owe money and the debtor forgives the debt, what that really means is that they paid the debt for you. If they paid the debt for you it is the same as if they paid you and then you paid the debt. So, the debt paid is considered income. (Another way to think about this: If this were not the case then we could all have our employer just by our food, housing, entertainment, etc. and we would never have any income to report and no one would ever need to pay taxes.) Since the debt that is reduced or forgiven is income you may now owe income tax on that portion that was eliminated. So not only did you lose your house because you couldn’t make the payment, but now you have a big tax bill to boot!

Relief for a Short Period of Time

Because the housing crisis is so big, and in an effort to lessen the economical impact of the foreclosures, in December 2007 President Bush signed the Mortgage Debt Forgiveness Act of 2007. The act allows for mortgage debt relief to not be included in income for those whose mortgage debt is forgiven between January 1, 2007 and December 31, 2009. So, if losing your house is inevitable, I guess now is a “good” time to do it.

Some of the “Nitty Gritty” Details

Probably the most important footnote to this is that only the portion of debt that was used for the construction, purchase, or significant improvement of the home qualifies for the benefits of the Act. In other words, if you used part of the money from your mortgage to consolidate debt or pay for a vacation, etc., then that portion is still considered income and is subject to taxes. For example, if the amount of money used for things other than the home is $55,000 and the amount of debt forgiven is $90,000, then only $35,000 of the debt relief is not included in taxable income.

A second important note is that this tax relief only applies to a principal residence. So, if it is a second home or a vacation home then the debt forgiveness will be treated as it always has – taxable income.

There are a few other details to the Act as well, but they don’t apply to most people and/or they aren’t within the scope of this BLOG. My intention is just to give you an idea of the overall tax consequences of debt forgiveness and the effects of this Act.

* This article is commentary on basic principles. In no way should the things said in the article be construed or interpreted to be advice for your specific situation. Before making any financial decision you should consider all factors and consult with a professional.