Forgiven Mortgage Debt May Lead to Huge Tax Bills

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Congress passed the Mortgage Forgiveness Debt Relief Act during the national housing crisis. This little-publicized law protected those who lost their principal residences to a foreclosure or short sale from a big tax bill, and it is expiring at the end of 2012. This means that those who lose their homes or receive a partial loan reduction next year may be facing a huge tax bill. (See also: How Foreclosure, Deed in Lieu, and Short Sale Affect Credit Scores)

Most people are not aware that most debt forgiven by a lender is taxed as ordinary income by the IRS. In the case of a foreclosure or short sale, the lender usually issues a 1099-C to the borrower for the balance still owed, minus whatever the bank sold the house for. Issuing a 1099-C means that the lender will no longer go after the borrower for the loan, and hence, the debt is forgiven or canceled. In cases where homeowners walked away from their houses, it is very easy to get an "income" of thousands of dollars, and the IRS will once again tax that income at the borrowers' highest marginal rates.

For example, suppose that a couple with an annual income of $70,000 owed $500,000 on their loan when their house was foreclosed, and the bank sold their house for $150,000, then they would have a 1099-C with a balance of $350,000. If that foreclosure happened on January 1, 2013, then this couple would have a taxable income of $420,000 for the year 2013 in the eyes of the IRS. This means that this couple would owe over $100,000 to the IRS. To complicate the matter, many states also passed tax laws that conformed to the federal law. So those who have discharged debt on their principal residences in 2013 will also have to pay state income taxes on their loan balance. In California, this would add approximately another $30,000 to this fictional couple's tax bill.

Even if an underwater homeowner manages to get a principal reduction on their loan and keep the house, the loan forgiven will be considered ordinary income starting next year. Not all cancelation of debt is taxable, and you can read about the details of the law. This change will affect those who have money and want to walk away from their loans the most since the IRS will not tax insolvent folks. A person is insolvent if his or her total debt is more than the sum of his or her assets, so those who really have nothing to pay will not be affected.

Since there is no guarantee that Congress will extend this law into 2013 and beyond, if you are underwater on your mortgage, then this year may be the last year to finish up a foreclosure or principal reduction without incurring a tremendous tax bill. For those considering a short sale, it is best to get the process started right now, since it may take many months for a short sale transaction to actually close.

I think the expiration of this law might change the decision-making process of many underwater homeowners if they knew about it.

What do you think? Should this law be extended? If you are underwater on your mortgage, would a potentially huge tax bill prevent you from walking away from your house?