An important federal income tax provision that provides relief on the forgiveness of mortgage debt is scheduled to expire at the end of 2012. If this tax provision is not extended, there could be a significant effect on homeowners who are forced into foreclosure or a short sale.
Generally, the forgiveness of debt is subject to federal income tax. This includes the debt that a bank forgives as a result of a foreclosure or short sale. But as indicated by the IRS, the Mortgage Debt Relief Act of 2007 allowed taxpayers to exclude from taxable income the discharge of debt on their principal residence. This was a temporary tax provision that was extended until December 31, 2012.
Up to $2,000,000 of foreclosure debt or up to $1,000,000 for married taxpayers filing separately, has been eligible for this tax relief. The relief applies to mortgage restructuring, foreclosures, and short sales when the bank forgives the remaining balance due after the short sale.
According to the National Association of Realtors, more than a quarter of a million short sales were completed in the first quarter of 2012. And some analysts speculate that short sales will increase toward the end of 2012, prior to the expiration of the mortgage debt relief tax provision.
An article in The Builders Magazine points out that the potential problem is especially intense in Nevada because of a large backlog of mortgages in default. The foreclosure has not even begun, because foreclosures have been halted for almost a year due to changes in the procedures banks must follow under Nevada law.
As reported by CNBC, the Senate Finance Committee has passed several tax extensions, including a one-year extension of the mortgage debt relief provision. But the House of Representatives has not yet decided on these extensions. According to the article, one Capitol Hill watcher gives the extension about a 60-40 chance of passing.
If the mortgage debt relief act is not extended, one possible way to avoid having to pay federal income tax on the canceled debt would be through the insolvency exclusion. According to the IRS, forgiven debts do not have to be included in taxable income if you are insolvent; that is, your total liabilities exceed your total assets. Other exceptions include exclusion if the debt was discharged in a Title 11 bankruptcy, if the debt is qualified farm indebtedness, or qualified real property business indebtedness. To qualify for any of these exceptions, IRS Form 982 must be filed.
