By: Joseph Sacco Jr, Esq.
The Mortgage Forgiveness Relief Act which was extended on January 2, 2013 as Section 202 of the America Tax Payer Relief Act is set to expire at the end of this year, specifically January 1, 2014.
The expiration of this law could have tremendous tax consequences for homeowners involved in short sales, foreclosures, or deeds in lieu of foreclosure where the lenders cancel or forgive the deficiency balances. In many cases, individuals could end up with a hefty tax bill even after a foreclosure or a lender approved short sale.
When a financial institution forgives debt in the amount of $600.00 or more, they must issue a 1099C and disclose this to the IRS and to the borrower. The IRS would treat any forgiveness of debt from a financial institution as income. However, the Mortgage Forgiveness Debt Relief Act which was originally signed into law in 2007, gave some homeowners the ability to exclude canceled/forgiven debt from their income. If the debt being cancelled stemmed from a loan that was used to buy, build or improve a primary residence and secured by that primary residence and the balance of the loan was $2 million or less, then the homeowner could exclude the cancelled debt and avoid tax liability. They would need to file a Form 982 where they would report the amount cancelled matching the 1099C received from the lender. The exclusion does not apply to vacation homes, investment homes or loans over $2 million. The law expired at the end of 2012 but was extended for 1 year under the America Tax Payer Relief Act of 2013, the so-called Fiscal Cliff Law signed on January 2, 2013.
However, with the end of the year around the corner, along with the expiration of this law once again looming, will homeowners whose debts are cancelled by short sales, foreclosures or deeds in lieu be subject to large tax bills that will extend their financial problems to the point of despair? Not necessarily, for three reasons:
- Like at the end of 2012, Congress and the President can extend the law again relatively easily. And they do not have to extend it before it expires. They could extend it at any point and make it retroactive. This is the obvious solution that many are watching the news in hopes of seeing.
- The homeowner may exclude any debt that is canceled by a Title 11 Bankruptcy Order which would include a Chapter 7, Chapter 11, and Chapter 13 Bankruptcy.
- The homeowner may have been insolvent at the time of debt cancellation.
Since many individuals may elect not to file for bankruptcy for a variety of reasons, I will focus on the Insolvency Exclusion.
Insolvency has been a way to exclude cancellation of debt for years and it is not tied to an expiration date at this time. According to the IRS Rules, a person is insolvent if all of his liabilities exceed the fair Market Value of his assets. Assets include everything the taxpayer owns, and liabilities include everything the taxpayer owes.
IRS Publication 4681 will show the complete list of assets and liabilities the IRS uses to make these calculations.
To illustrate how the Insolvency Test may work, let’s look at two examples. If Joe short sells his house and the debt cancelled is $50,000.00, Joe will receive a 1099C from the lender. If Joe’s total liabilities at the time of cancellation including the mortgage on the property is $165,000.00 and the FMV of his assets including the principal residence is $100,000.00, then Joe is insolvent by $65,000.00 and can exclude the entire $50,000.00 from his income since it is less than the amount Joe is insolvent by.
However, if at the time of cancellation Joe’s total liabilities including the mortgage were $165,000.00 but the FMV of his assets including the house were $125,000.00, then Joe is insolvent by $40,000.00 and can only exclude $40,000.00 of the cancelled debt. Joe must include $10,000 of the cancelled debt on line 21 of his 1040 Tax Return (unless there is another exclusion).
Just to clarify, if the current law is extended than Joe would be able to exclude $50,000.00 regardless of the fair market value of his assets as long as this was his primary residence under the Qualified Principle Residence Indebtedness Exemption.
If the Qualified Principle Residence Indebtedness Exemption contained in the Mortgage Debt Relief Act of 2007 as Extended by the America Tax Payer Relief of Act of 2013 is not extended the homeowner may still have the insolvency exclusion available to them to reduce or eliminate the tax liability.
For more information please contact your tax professional.
Joseph Sacco, Jr. is licensed to practice law in South Carolina and New York and is an Associate Attorney in the Foti Law Firm with offices in Daniel Island and Mt Pleasant. The Foti Law Form serves all of your real estate needs in Charleston, Berkeley and Dorchester Counties.