The threat of losing our houses in foreclosure is always very stressful. It is not necessarily news to many homeowners nowadays that foreclosure rates are already at an all-time high. Properties are being foreclosed by lenders left and right. Homeowners are being preoccupied with the daily grind of paying off mortgages or catching up payments on delinquent accounts. With so many problems that homeowners are dealing with nowadays it is not necessarily pleasant news to know that if and when a homeowner’s efforts to save a house fail; and, their properties are finally foreclosed by lenders, they may still yet face a new problem of being liable for “income” taxes on the foreclosed property with the Internal Revenue Service (IRS).
This is a very common situation with homeowners who bought a house (or a townhouse or a condo) within the last few years. A homeowner, for example, may have bought his real estate property in 2005 and then suffered financial reverses when the property values declined in 2008. Unable to keep up with mortgage payments, many homeowners in this situation had their properties foreclosed in 2009.
For a specific example, let us assume that at the time of foreclosure in 2009, the mortgage balance still owed by the homeowner to the lender was $550,000. The house was foreclosed and sold at a foreclosure sale for only $350,000. Fortunately for the homeowner, the unpaid balance of $200,000 was cancelled by the lender. Unfortunately for the homeowner, however, the lender issued an IRS form 1099 to the homeowner for the cancelled debt. How is this $200,000 cancelled debt treated by the IRS? Is this taxable?
If you borrow from a bank and the bank cancels or forgives your debt, the amount of debt that is cancelled is considered “income” for federal tax purposes. This is considered “income’ because money was lent to you and you are no longer required to repay it. Hence, cancelled debts are generally taxable.
Fortunately for many homeowners, however, the Mortgage Forgiveness Debt Relief Act of 2007 grants some relief to homeowners. This law gives tax relief to homeowners who would otherwise be taxed on the cancelled debts for qualified principal residences. It should be noted, however, that this debt relief act is limited by the following:
1. It only applies to a debtor’s primary home. It will not apply to second homes, vacation homes or investment properties.
2. The indebtedness that was forgiven was incurred for the purpose of acquiring, constructing or substantially improving the principal residence of the debtor. Hence, home equity debts which were incurred not to improve the home but are mortgage debts not related to the home such as educational, medical or consumer debts remains subject to income.
3. This law is only temporary and only applies to discharge of debts between the calendar years 2007 and 2012.
Homeowners losing their principal homes via foreclosure (though also applicable to short sales, or deeds in lieu) within the next 3 years will benefit greatly from the Mortgage Debt Relief Act. However, homeowners who are not covered by this Act, may have to do some bit of tax planning in order to soften the impact of the “income” taxes due on their foreclosed properties.
(DISCLAIMER: material presented above is intended for informational purposes only. It is not intended as professional advice and should not be construed as such. Rey Tancinco is a partner at Tancinco Law Offices, a professional corporation with offices in San Francisco, Vallejo, and Manila. The law office website is at: tancinco.weareph.com/old. Rey Tancinco can be contacted at (800) 999-9096 or (415) 397-0808 or via email at: attyrey@tancinco.com
