Advice for Homeowners with an Underwater Mortgage: Short Sales and Taxes - IRS Gives You a Break

If you have to sell a house with an underwater mortgage, your lender may forgive a portion of the debt. If this happens, the IRS looks at the forgiven debt as income that may be taxable. The good news for many homeowners is that the government may cut you some slack and not may you pay taxes on the forgiven debt. The Mortgage Debt Relief Act of 2007 allows many homeowners to exclude income from the discharge of debt on their principal residence. This isn't only for short sales. You may get a tax break even if you debt is reduced through mortgage restructuring, or if part or all of a mortgage is forgiven in a foreclosure. This provision applies to debt forgiven from 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion if you are married and filing jointly, and $1 million if married filing and separately. This tax break applies only if the forgiven debt is directly related to a decline in the home's value or the taxpayer's financial condition. The following are the most commonly asked questions and answers about The Mortgage Forgiveness Debt Relief Act and debt cancellation: What is Cancellation of Debt? If you borrow money from a commercial lender and the lender later cancels or forgives the debt, the amount that you didn't pay back is normally reportable as income because you no longer have an obligation to repay the lender. Here's a simple example of forgiven debt. You borrowed $10,000 but defaulted after paying off $2,000 of the principle. If the lender can't collect the remaining $8,000, that amount is considered taxable income in most cases. When is cancellation of debt not taxable? The most common situations when cancellation of debt income is not taxable is when it involves: A qualified principal residence (This is what the Mortgage Debt Relief Act of 2007 and applies to most homeowners. Debts discharged through bankruptcy. Insolvency (when your total debts are more than the fair market value of your total assets). Non-recourse loans, which is a loan where you are not personally responsible because the property being financed is used as collateral. Your particular case may be more complicated, so if you are confused, hire professional tax or legal help. What if I don't tell the IRS? Don't count on getting away with it by not telling the IRS. The lender is usually required to report the amount of the canceled debt to you (using Form 1099-C) and to the IRS. The amount of debt forgiven must be reported on IRS Form 982 and this form must be attached to your tax return. If you don't report it, and the IRS expects to see you mention it in a tax return, you could be headed for an audit. Related Resources More information, including detailed examples can be found in Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments. Also see IRS news release IR-2008-17.

SOURCE : Mortgage311.org