Foreclosure Tax Reform Could Help Millions

The tax code allows for a foreclosure tax (for lack of a better word) when the lender forgives any part of the original mortgage debt. The IRS treats taxes the forgiven amount as income.

For many facing foreclosure over the next few years, a loan modification called a “short sale” will seemingly be the proverbial answer to prayers…until the IRS steps in levying this foreclosure tax.

Ouch!

Let’s run through an example so you can see how punitive this foreclosure tax can be.

Say you are one of the many subprime loan holders and you’ve suffered a $50,000 loss in value on the home you bought 2 years ago. The payment adjusted upward and you got behind eventually defaulting on the loan causing the lender to foreclose. You intelligently contacted the lender and asked for a short sale package as a means to get out of the home. You sold the home a few months later for $50,000 less than your loan balance and the lender agreed to forgive the $50,000.

You are very happy to get out of the loan without a foreclosure on your record.

But wait, it’s not over.

The example above also triggered a “taxable event” which will cost you the following: If you are in the 35% tax bracket, you’ll owe the IRS 35% of $50,000! It’s just like you got a bonus at work for $50,000…you gotta pay the tax the following year.

Tax owed: $17,500
So you just came out of the worst financial nightmare of your life only to be hit at the end of the year with 1099 form from the old “helpful” lender informing you (and the IRS) of the $50,000 income you’ll now owe tax on.

This same taxable event can occur without a short sale. Anytime the lender gets less than the loan balance, you are said to have benefited. So even in a deed in lieu where you give the lender the deed and they agree not to foreclose or even a standard foreclosure, should they not be able to sell the house and reclaim all their money, you’ll be the one paying.

Do you think that’s fair?
I don’t.

And neither do a many Congressional leaders who have introduced “The Mortgage Cancellation Tax Relief Act of 2007″ (HR 1876) to eliminate this foreclosure tax from the law. The above scenarios will happen to millions of Americans over the coming years, so I hope the politicians can pass this legislation quickly.

But I’m not holding my breath…and neither should you!

Plan accordingly if you find yourself seeking a short sale, deed in lieu, or standard foreclosure.

If you need a step-by-step guide on taking advantage of foreclosure tax reform check out ourforeclosure ebook.

Good Luck!

Update: President Bush signed the The Mortgage Cancellation Tax Relief Act of 2007 (HR 1876) in law on December 20, 2007 changing the rules to allow for a mortgage debt forgiveness as a NON-taxable event! This law also extended the tax deductibility of mortgage insurance payments through 2010.

Author: Rob K. Blake
Published January 19, 2008
Modified February 26, 2008

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