Mortgage Forgiveness Debt Relief Act
Mortgage loans are not taxable income because the recipient is obligated to pay the lender back in full except for a few exceptions. For example, any loan over $600 that is cancelled or forgiven, either entirely or in part, by a commercial lender, is considered by the IRS to be taxable income. They consider that once a loan is forgiven the taxpayer is relieved of any obligation to pay the money back so feel that the taxpayer has received free money. To avoid this windfall resulting from debt cancellations, the IRS taxes all Cancellation of Debt (COD) income with a few exceptions.
Exceptions From Debt Cancellation
Prior to the Mortgage Forgiveness Debt Relief Act in 2007, the two most common tax-exempt income were income from bankruptcy and insolvency, which is when a person’s total debts exceed their total assets. The Mortgage Forgiveness Debt Relief Act further added another category of tax-exempt COD income to his including qualified principal residence indebtedness, which is income realized as a result of mortgage restructuring or foreclosure on your principal residence.
Determine If Your Loan Qualifies
The Mortgage Forgiveness Debt Relief Act applies to any income resulting from debt forgiveness in connection with a taxpayer’s principal residence. Your principal residence is the property where you spend the majority of your time and for most people, this is the place they call home.
There are a few additonal requirements that need to be met before a loan can qualify for tax-exempt status under the Act:
- The loan must have been secured between 2007 and 2012.
- The debt must have been incurred for the purpose of buying, building, or substantially improving the taxpayer’s principal residence. In other words, if you refinanced your home and used the money for any other purpose, such as paying off credit cards, this money will not qualify for tax relief under the Act.
- The loan must be secured by the taxpayer’s principal residence.
- The debt cannot be discharged for any reason other than: (a) a depreciation in the property’s value, and/or (b) a change in the property-owner’s financial situation.
- The debt to be excluded from income tax is limited to $2 million per year (or $1 million if you are single or filing individually).
Impact on California Short Sales and Foreclosures
There are many upside-down homeowners who may benefit from the tax relief afforded by the Act. For instance, if you complete a short sale before the Act expires, and meet the requirements of the Act, you will not be taxed on the difference between the selling price and the amount you owe or if your lender foreclosed on your home before the Act expired you will not be taxed for the cancelled debt.
Of course, there are many other factors aside from any potential tax break to take into consideration when deciding whether to walk away from your home. The decision to short sell or foreclose your home should be an informed and well advised one. Our mortgage attorneys are well versed in the tax implications of debt cancellation and are happy to inform you about your rights and obligations by offering a free consultation.