By definition, loans are not taxable income because the recipient is obligated to pay the lender back in full. However, with a few exceptions discussed below, any loan over $600 that is cancelled or forgiven, either entirely or in part, by a commercial lender, is considered by the IRS to be taxable income. The reason being is this: once a loan is forgiven, or debt cancelled, the taxpayer is relieved of any obligation to pay the money back – in essence, the taxpayer has received free money. To avoid a windfall resulting from debt cancellations, the IRS taxes all Cancellation of Debt (COD) income.
Exceptions to Taxable Income From Debt Cancellation:
Prior to the adoption of the Mortgage Forgiveness Debt Relief Act in 2007, the two most common tax-exempt COD income were income from bankruptcy and insolvency (when a person’s total debts exceed their total assets). The Mortgage Forgiveness Debt Relief Act added another category of tax-exempt COD income: qualified principal residence indebtedness, a fancy term for income realized as a result of mortgage restructuring or foreclosure on your principal residence.
How to Determine If Your Loan Qualifies:
The Mortgage Forgiveness Debt Relief Act applies to any proceeds (income) resulting from debt forgiveness in connection with a taxpayer’s principal residence. Your principal residence is the property where you spend the majority of your time – for most people, this is the place they call home.
There are a few requirements that need to be met before a loan can qualify for tax-exempt status under the Act:
- The loan must have been secured between 2007 and 2012.
- The debt must have been incurred for the purpose of buying (ex. Mortgage), building, or substantially improving (ex. Refinancing) the taxpayer’s principal residence. In other words, if you refinanced your home and used the money for any other purpose, such as paying off credit cards, this money will not qualify as COD income and consequently will not qualify for tax relief under the Act.
- The loan must be secured by the taxpayer’s principal residence.
- The debt cannot be discharged for any reason other than: (a) a depreciation in the property’s value, and/or (b) the property-owner’s financial situation.
- The debt to be excluded from income tax is limited to $2 million per year (or $1 million if you’re married but filing separately).
Impact of the Act on Short Sales and Foreclosures:
With the Mortgage Debt Relief Act set to expire by the end of 2012 and the possibility of an extension remaining uncertain, homeowners all over the country are considering short selling or walking away from their homes before the end of 2012 in order to receive the tax relief promised under the Act. In truth, many upside-down homeowners may indeed benefit from the tax relief afforded by the Act. For instance, if you complete a short sale before the Act expires, and meet the requirements of the Act, you will not be taxed on the difference between the selling price and the amount you owe. Likewise, if your lender forecloses on your home before December 31st, you will not be taxed for the cancelled debt.
Cautionary Note: If you have not already begun the process of negotiating with your lenders to agree to a foreclosure, it may be too late. According to a recent study conducted by Lender Processing Services, lenders take 22 months on average to process a foreclosure. In addition, if you happen to live in one of the 24 judicial states that require a judge sign off on all foreclosures, the process is taking an additional five months. Unless Congress chooses to extend the Act before the end of 2012, the reality is that the window may have already closed for foreclosures.
As far as short sales go, some agents claim that a short sale can be completed within three months (the average timeline is somewhere around 10 months). However, even assuming this is true, at least in some states, including Arizona, the Act does not apply to a vast majority of the population. In Arizona, for instance, purchase-money-mortgages on real property are considered non-recourse loans under a state anti-deficiency law. In other words, since the loan is secured by the property, the lender has no other recourse aside from the property itself. Disposing of the property in a foreclosure leaves the lender with no other recourse. In a sense then, the loan has not been forgiven. Consequently, the loan does not qualify as COD income under the Act.
Of course, there are many other factors aside from any potential tax break to take into consideration when deciding whether to walk away from your home. The decision to short sell or foreclose your home should be an informed and well advised one. The attorneys at McCarthy Law are well versed in the tax implications of debt cancellation and are happy to inform you about your rights and obligations. Give us a call today to set up a free consultation.
Kevin Fallon McCarthy
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