As we all know, the recent global financial crisis has forced thousands of homeowners to give up their homes through foreclosures. To make matters worse, these homeowners had to contend not only with the loss of their homes but the resulting tax liabilities they ended up owing to the IRS.
When a homeowner fails to pay a loan that is secured by a home, the lender will foreclose on the loan. The home will be auctioned in a trustee sale and the proceeds from the sale, if any, will go to the lender as payment on the loan. However, nowadays most homes are “under water” wherein their fair market value is much lower than the amount of the principal balances of the loans.
Foreclosure is a stigma and so many homeowners opt for a “short sale.”A short sale is the selling of a home for less than the amount of the loan secured by the home or the mortgaged debt. In most short sale transactions, the home is about to be foreclosed for failure to pay the mortgage and so homeowners avoid the negative impression that their house was foreclosed. But in a short sale, there is the danger that a homeowner could be liable for tax due to a “cancelled debt.”
In some cases, where homeowners simply walked away from their homes or abandoned them under the impression that the lenders will no longer collect their indebtedness, banks issue a 1099 for the difference between the fair market value of the property and the principal balance of the loan. For instance, Mr. Cruz owns a home owes $400,000.00 to Bank ABC. If Mr. Cruz walks away from the house or abandons it and the fair market value of the property is $200,000.00, Mr. Cruz could be liable for the tax of the $200,000.00.
Whatever may be the manner by which a homeowner gives up his home, he could still be held liable for taxes depending on whether a gain or loss is realized from it. Under the Tax Code, a cancellation of debt could give rise to tax liabilities. Thus, in the situations given above, if the house was sold in a short sale or abandoned by the homeowner, there could be tax consequences for the deficiency. Under tax laws, the homeowner would be deemed to have received an income to the extent of the deficiency. In such situation, the lender would report this canceled debt to the IRS as income to the homeowner by issuing a Form 1099.
But thanks to the Mortgage Forgiveness Debt Relief Act of 2007, the canceled debt resulting from foreclosure, short sale, abandonment or loan modification can now be excluded from a homeowner’s taxable income. Under this law, cancelation of debts used to buy, build or substantially improve a homeowner’s residence is excludible from taxable income. This debt is called qualified principal residence indebtedness and the maximum amount a taxpayer can claim as qualified principal residence indebtedness is $2 million or $1 million if married filing separately.
As in any law, there are certain criteria that must be met before a homeowner can avail of this exclusion. And, in my experience, even if a homeowner clearly qualifies for this exclusion, reporting the cancelation in a wrong manner can result in a denial of this benefit. I’ve seen several cases where taxpayers audited by the IRS ended up having tax liabilities on canceled debt because the tax preparer made a mistake in properly reporting the canceled debt.
If your home has been foreclosed, was the subject of a short sale or loan modification, you might just qualify for an exclusion from your taxable income of any resulting debt cancelation. See your tax professional now so they can help you save money by paying less in taxes.
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Edgardo M. Lopez is an attorney licensed to practice in the Internal Revenue Service and the United States Tax Court. He has been an attorney for 25 years and he is a member of the American Society of Tax Problem Solvers. His IRS practice is throughout the United States and he has offices in the entire State of California (Los Angeles, San Francisco, and San Diego). His office has an A+ rating with the Better Business Bureau.
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