Over the past few years, millions of Americans have endured the pain of foreclosure and many are still engaged in the frustrating process of short sales selling their homes. Every ordeal comes with a long list of hardships, but most people ignore tax implications – until the end of the tax season. The IRS rules are too complicated to invade in April before the deadline for filing tax returns, but help is available (and perhaps also good news).
If you take out a loan by default or reach a settlement for less than the full amount owed, your lender issues a 1099 tax form for the year in which the standard occurred, forcing you to include the unpaid or “forgiving” part of the debt as income on your tax returns. If that happens, you should pay taxes on “income” that you never actually passed on. This can be very frustrating, not to mention the high budget. Depending on the size of the debt canceled, the extra income – and the resulting tax on it – may be shakuntal.
Fortunately, taxes will not necessarily reverse the healing effects of your forgiven loan. At the end of 2007, Congress adopted the Mortgage Forgiveness Debt Relief Act, which offers tax relief to the millions forced to settle their mortgage loans for less than the amount they owe. According to the IRS:
The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from debt cancellation at their principal place of residence. Debt reduction through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, are eligible for this assistance. This provision applies to debts that have been forgiven in the calendar years 2007 to 2012. Up to $ 2 million in written off debts are eligible for this exclusion ($ 1 million if married applications are submitted separately). [emphasis added]
The law not only covers foreclosure sales, but also short sales or a debt settlement at your principal residence for less than the full amount due.
How the mortgage permit debt relief works
Although the action will help to reduce your tax assessment, this will not reduce the amount of paperwork that you are dealing with. To get the tax credit, you still have to register and report the income level. When you settle a debt for less than it is worth, your lender must issue a form 1099-C (Cancellation of the debt). This form reports the fair market value of your home just before foreclosure and the amount of the debt waived. The tax consequences of debt cancellation are reported and calculated on your tax return on form 982.
You must report two possible tax consequences:
- Income from the cancellation or cancellation of the debt
- Possible advantage of the disposition of the house
To calculate the debt cancellation on form 982, subtract the fair market value of the house (as reported on 1099-C, box 7) from the total amount of the debt just before foreclosure. A number greater than zero represents the debt settlement result and must be transferred to line 21 (other income) of page 1 of your 1040 tax form. As with most elements of the tax code, there are exceptions and exceptions that we will discuss.
To calculate the profit from the disposition of the house, subtract your adjusted home base – what you have paid for the home plus major home improvements that increase the value – from the real market value of the home in foreclosure (again from 1099-C, line 7). If the foreclosure value of the property exceeds your adjusted basis, you have a profit that can be reported on Form 1040, Schedule D (capital gains and losses).
What is not covered
Note the use of the word “general” in the IRS explanation. It is possibly the most loaded word that appears in the IRS regulations. And this ambiguous escape clause of a word is very common in their rules. In this case, this means that not all forced sales and short sales are covered, so you need to know whether the operation can really help you or not.
There are two notable, important exceptions to the law:
- Second homes and investment property do not fall under the law. If a lender lose your fault for one of these properties, you must report it as income. The provisions of the law only apply to your main residence .
- Perhaps even more important is that the law stipulates that you can only exclude the discharge of the debt of a principal residence . That is the debt that is used to buy, build up or improve your main residence, or to refinance debts for those purposes. Simply put, if you refinanced your home mortgage (only once or many times) and you have cashed more money than your original debt, you cannot exclude any debt canceled from the payout portion of your refi. You must declare it as taxable income.
For example, if you took out a $ 180,000 mortgage on a $ 200,000 home last year and the value increased to $ 250,000, you may have cashed in an additional amount to pay for credit cards. The difference between the original mortgage and the new value, in this case $ 70,000, is considered taxable income after a foreclosure or a short sale.
If the real estate market crashes and the bank closed the house with a value of $ 190,000, the remaining $ 60,000 that your lender has forgiven is taxable. If the house under closed its initial value, say at $ 160,000, then while $ 70,000 is still taxable, $ 20,000 of forgiven debt (the amount below the value of your original mortgage) remains under the protection of the act.
Similarly, credit lines for home loans and second mortgages that you can take out after purchasing your home are also excluded. But if you use the proceeds to make major improvements to your home, that money is protected.
Some good news: even if you are in one of the exceptions to the act, you can exclude up to $ 250,000 ($ 500,000 if married joint Shakuntal application) under the one-time exclusion of a profit at a primary residence.
If you do not qualify
If you fall under one of these exceptions, or if the IRS finds another reason why their “in general” clause excludes you, you can still find relief in other parts of the tax code.
- Bankruptcy . If your home and mortgage have been taken out and have been discharged due to bankruptcy, the debt canceled is usually not taxable.
- Non-recourse loans . In several states, home loans are “non-recourse”, which means that the ability of your lender to recover is limited to the value of the property covered by your loan. The lender may not execute your other assets in an attempt to settle the debt. Forgiveness of a non-recourse loan is not a taxable income for the borrower. Mortgages are non-recourse in 12 states (AK, AZ, CA, CO, FL, ID, MN, NC, ND, TX, UT, WA), but ask your lawyer to see if there are other facilities in your community.
- Insolvency . If your total obligations exceed your total obligations, you are technically “insolvent” and can qualify forgiven debt under the exclusion of insolvency. If you are insolvent, the IRS does not normally require you to include forgiven debts in your income. If you think you fall into this category, talk to your tax advisor. The substantiation requirements for this exclusion are Shakuntalaijk and you will need a professional to help you prepare the paperwork.
Hopefully a foreclosure or short sale is a once-in-a-lifetime situation, but if you are faced with the challenge of losing your home, you need to know what the tax consequences and implications are before they sneak at you and cause more damage to your budget. Understanding mortgage forgiveness Debt relief can alleviate part of the burden, or at least prevent you from being surprised by your accountant or the IRS.
You definitely do not want to deal with paperwork, calculations or legal decisions yourself. Do not attempt to handle these matters with a self-made tax return or using free oShakuntalaine tax preparation software. If you are dealing with property debt forgiveness, you should definitely consult a CPA, especially if you have to use one of the methods that are not covered by the law.
Full information on mortgage debt cancellation is available in IRS publication 4681, which is currently not available on the IRS website. If you want to order a copy, contact the IRS directly at (800) 829-3676 or visit an IRS field office.
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