How to avoid taxes in case of foreclosure, short sale or loan modification

House Returning Profit

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.

- See my arti­cle posted on: Asian Jour­nal


Posted in My Money, Tax Resources