Foreclosure Defense and Short Sales: Tax Consequences

Question: Do I have to pay taxes on the amount the bank forgave when they foreclosed on my house?

Answer: Sometimes. It depends on a lot of factors, but for many residential homeowners, the answer may be No.

Many homeowners default on their mortgage and note. Often, these homeowners (or their attorneys) will negotiate with the bank to receive a principal reduction on the amount of the loan, or give the bank a deed in lieu of foreclosure, or do a short sale.

This will help you how to find out whether you have to pay taxes on the amount of the loan that was forgiven.

First, an example. Let’s say that in 2007 you took out a $200,000 loan to buy your home. You’ve paid down $20,000, and still owe $180,000.  The payments have increased, your paychecks decreased (or stopped coming altogether) and despite your best efforts, you ended up missing several payments and defaulted on the loan.

Under the Mortgage Forgiveness Debt Relief Act of 2007 (“MFDRA”), the homeowner may be eligible for an exclusion if:

1. the property is residential, and
2. the balance on the loan is $2 million or less, and
3. the mortgage or mortgages was/were used to buy or improve the property, and
4. the owner lived there for at least 2 out of the last 5 years, and
5. the debt was non-recourse (i.e., foreclosure was the bank’s only remedy after homeowner default), and
6. the discharge is related to a decline in value or the homeowner’s financial condition, and
7. the discharge is not related to services performed for the lender.

The MFDRA expires at the end of 2012 (though President Obama has included an extension to 2015 in his 2013 budget proposal). The exclusion limit is $1 million for a married person filing separately. Equity used for other purposes (e.g. paying off credit cards, other loans) may not be excluded. The MFDRA applies to foreclosures and modifications which qualify as above.

After the reduction, the lender is required to send the homeowner a 1099-C, Cancellation of Debt form. The homeowner must fill out IRS Form 982 when filing taxes that year.

If the MFDRA doesn’t apply, the homeowner may also exclude if he or she is insolvent (total debts exceed the total fair market value of all assets), at which point bankruptcy may be worth considering.

The IRS has some useful information on their web site which goes into much more detail. If you decide to take advantage of the income exclusion, I strongly recommend that you consult with an attorney. Whatever you decide, the government has provided an excellent tool to save you money.

ZIES WIDERMAN & MALEK is a law firm practicing civil litigation, real estate, and intellectual property law in Melbourne, Florida. To contact Mr. Thalwitzer, call (321) 255-2332 or email him at Aaron@LegalTeamUSA.com.