Short Sale Blog

Here is the latest short sale news at Seattle Short Sales. We assist hundreds of Seattle area homeowners with short selling their home and avoiding foreclosure.

The Mortgage Forgiveness Debt Relief Act of 2007

Seattle Short Sales - Tuesday, October 23, 2012

The Mortgage Forgiveness Debt Relief Act of 2007 became law on December 20, 2007. The aim of the Mortgage Forgiveness Debt Relief Act is to protect homeowners who have lost their home through foreclosure, or who have taken action to avoid foreclosure through a short sale or mortgage modification, from the double hit of having to then pay income tax on their forgiven mortgage debt.

Normally, forgiven debt is considered by IRS to be the same as taxable income. For example, if your lender forgives $100,000 of your mortgage debt, whether through foreclosure or via a short sale, that $100,000 would be considered taxable income for the year that that debt was forgiven. However, in recognition of the global financial crisis that has resulted in millions of American homeowners struggling to pay their mortgages, the Act was passed as a special provision, to relieve these homeowners of having to pay income tax on the forgiven debt.

The Mortgage Forgiveness Debt Relief Act originally applied only to homeowners who were foreclosed upon, or whose debt was forgiven, between January 1, 2007, and December 31, 2009. Its expiry date has since been extended to December 31, 2012. It is possible that that expiry date will be extended further, but so far no decision has been made about an extension.

The Mortgage Forgiveness Debt Relief Act applies only to mortgage debt that was owing on your principal residence. For your home to qualify as “principal residence”, you must have both owned the home and used the home as your principal residence for periods aggregating 2 years or more during the 5-year period ending on the date of the sale or exchange of the home. Other things to know:

  • The maximum amount you can treat as qualified principal residence indebtedness is $2 million, or $1 million if married and filing separately.
  • The Act applies to debt that is forgiven through foreclosure, through a short sale, or through modification of the terms of the mortgage. Forgiven debt is normally considered by IRS to be income. In IRS terms, what the Act does is allow you to “exclude” this income when filing your tax return.
  • The forgiven debt must have been used to buy, build, or substantially improve the residence. In other words, forgiven debt on both first and second mortgages can be included under the Act provided that the debt was used for one of those purposes - but not if it was used for other purposes, e.g. to pay off credit cards or to buy a new car.
  • The forgiven debt must be secured by that same residence.
  • Refinanced debt proceeds may also qualify for exclusion under the Act, provided that they were used to “substantially improve” the residence and not for other purposes.
  • Debt that has been forgiven on second homes or investment homes does not qualify for exclusion under the Act - but it may be exempt from income tax due to other exclusions such as Insolvency.

If your lender forgives more than $600 of your debt, they are required by law to issue you a 1099-C, Cancellation of Debt form. Make sure that you examine the form as soon as you receive it. Check that the amount of debt forgiven (listed in Box 2), and the fair market value listed for your home (Box 7) are both correct. If there are any problems with the form, have your lender correct them immediately.

To exclude forgiven debt from taxable income, fill out IRS Form 982 and attach it to your income tax return.

For more detailed information about excluding forgiven debt from your taxable income, through the Mortgage Forgiveness Debt Relief Act and through other exclusions such as Insolvency and Bankruptcy, download IRS Publication 4681.

If you are a homeowner, and would like to learn more about short selling your home, please go to: http://seattleshortsales.com/homeowners/

If you are a real estate agent, and would like to learn about our no-fee short sale service, please go to: http://seattleshortsales.com/agents/

Using the IRS Insolvency Clause For Mortgage Debt Relief Forgiveness

Seattle Short Sales - Wednesday, September 19, 2012

Home sellers and real estate agents who are concerned about the upcoming expiry of the federal Mortgage Debt Relief Forgiveness Act still have options for avoiding a tax bill from the IRS, according to Seattle Short Sales, Inc.

With the principal amnesty program set to expire on Dec. 31, 2012, the Bellevue, Wash., team of legal, tax and real estate professionals is assuaging fears that sellers will miss a valuable tax break if their short sales do not close by year end.

“This looming deadline is instigating a surge of short sales,” explains Ross Kilburn, who notes that short sales increased 25 percent nationwide in the first quarter of 2012 over the previous year. “What most homeowners and many brokers do not realize is that the IRS offers several non-expiring exemptions that allow sellers to circumvent the income tax assessed on forgiven debt.”

An estimated 11 million Americans are underwater on their mortgages, carrying nearly $700 billion in negative equity as they try to ride out the recession. With one in every five homes worth less than is owed, the U.S. government passed the Mortgage Debt Relief Forgiveness Act in 2007, and then renewed it in 2009, to help homeowners recover from the economic crisis.

Prior to the Mortgage Debt Relief Forgiveness Act, the IRS taxed most forgiven debt as income. Under the current laws, the Act temporarily suspends this penalty when a lender absolves a customer’s mortgage debt. In order to qualify for the federal relief program, underwater mortgage holders must demonstrate extreme financial hardship, whether from a layoff, retirement or unexpected medical costs. Up to $2 million of debt can be forgiven by lenders.

Although the Mortgage Debt Relief Forgiveness Act expires at the end of this year, many underwater homeowners who short sale their homes will still be able to use the insolvency clause to avoid paying income taxes. In order to avoid paying taxes on discharged debt under the insolvency clause, the total amount owed to all creditors must be greater than the fair market value of all the homeowner’s assets. Liabilities, such as mortgage debt, credit card debt, student loans and vehicle loans, are balanced against assets like the home, vehicles, jewelry, artwork, bank account balances and retirement savings.

If a borrower is insolvent, the discharged debt is not taxable, up to the amount of the insolvency. For example, if a seller has a combined debt of $400,000 and assets totaling $145,000, then up to $255,000 of debt can be forgiven without being taxed. Since any absolved principal above this amount brings the seller back to financial solvency, the balance beyond $255,000 is taxable.

“This overlooked insolvency exemption has the potential to help hundreds of thousands of homeowners across the U.S. who currently don't have access to this important information,” praises Dean Guske, a CPA based in Bellevue. “Kudos to Seattle Short Sales, Inc. for spreading their knowledge widely."

If you are a homeowner, and would like to learn more about short selling your home, please go to: http://seattleshortsales.com/homeowners/

If you are a real estate agent, and would like to learn about our no-fee short sale service, please go to: http://seattleshortsales.com/agents/

Insolvency, and Other Ways to Avoid Paying Income Tax on Forgiven Debt

Seattle Short Sales - Sunday, August 12, 2012

This article is Part 2 of a series on the tax implications of forgiven debt. Part 1 dealt with the Mortgage Debt Relief Forgiveness Act of 2007, which relieves homeowners of having to pay tax on forgiven mortgage debt. That Act expires at the end of 2012 - so Part 2 looks at other options for avoiding paying tax, and specifically at insolvency: what insolvency is, and how you can apply this clause.

It is the middle of 2012, and the Mortgage Debt Relief Forgiveness Act expires at the end of the year. Some homeowners and real estate agents might wonder if it is worth even listing a home for a short sale at this point, because they are concerned that the short sale might not close before the Act expires. They are worried that, after expiry of the Act, that any debt forgiven by the lender may be considered taxable by the IRS.

However, there are many exceptions that homeowners can use avoid paying income tax on forgiven debt that are outside of the Mortgage Debt Relief Forgiveness Act. And the exceptions don’t expire! This article lists some of those exceptions, and then focuses on the exception for “insolvency,” since that is an exception that will apply to many struggling homeowners:

Seller-financed debt:
If the person that you bought the property from actually financed your purchase, i..e. your mortgage is with the seller of your property, you are exempt from having to pay income tax on any of that forgiven debt.

Title 11 Bankruptcy:
If you are in Title 11 bankruptcy proceedings at the time that your lender forgives the debt, you are exempt from having to pay income tax on the forgiven debt. Title 11 Bankruptcy includes bankruptcy filings under Chapter 7, 11 or 13.

Insolvency:
Many people do not realize that, if they are insolvent at the time that the lender forgives the debt, they do not have to pay income tax on the forgiven debt.

Insolvency means that the your debts are greater than the fair market value of all the things that you own - including any cash in your bank accounts, as well as retirement savings (e.g. IRA accounts and 401(k) and your interest in any pension plans).

If the amount you owe (not just on your mortgage - on car loans, credit cards, everything) is more than the value of what you own, then you are insolvent. You must do this calculation for the time immediately before the debt was forgiven. If you are insolvent, the forgiven debt is not taxable - at least to the point that the forgiven debt does not make you solvent.

Here are some examples:

Example 1. Jessica is insolvent. She does not have to pay income tax on any of the forgiven debt:
Jessica owed $300,000 on her mortgage. She could not afford to keep making her mortgage payments, but her home was only valued at $210,000. Following the short sale, she paid her mortgage off for $180,000 (after closing costs). Her lender waived the $120,000 deficiency - this means that her forgiven debt was $120,000.

 Jessica was worried that she would have to pay income tax on the $120,000 - but she looked up the insolvency clause.

Immediately before the debt was forgiven, Jessica owed:
mortgage debt: $300,000
car loan: $12,500
credit cards: $8,000
student loan: $32,000
TOTAL OWED: $352,500
Immediately before the debt was forgiven, the assets Jessica owned were:
bank account: $600
home value: $210,000
car (fair market value): $15,000
household goods, clothing, etc.: $5,000
TOTAL  ASSETS OWNED: $230,600
At the time that the lender waived her deficiency, Jessica owed $352,500. Everything she owned was worth $230,600. This means that she was insolvent by $122,500.
Even the amount of the forgiven debt does not bring her back to solvency. This means that she does not have to pay income tax on any of the forgiven debt.

Example 2. Bryan is insolvent, but the amount of the forgiven debt brings him back up to solvency. He must pay income tax on part of the forgiven debt.
Bryan was self-employed, and owed $450,000 on his mortgage. The economic downturn caused his business to slow down, and his son required medical treatment. He could not longer afford to make his mortgage payments. But his home was now worth only $350,000.

His lender approved a short sale, accepting $320,000 net proceeds and waiving the $130,000 deficiency balance. Bryan still had outstanding medical bills to pay, so he looked up the insolvency clause.

Immediately before the debt was forgiven, Bryan owed:
mortgage debt: $450,000
car loan: $25,000
credit cards: $3,000
business debts: $40,000
outstanding medical bills: $60,000
TOTAL OWED: $578,000
Immediately before the debt was forgiven, the assets Bryan owned were:
bank account: $2,000
home value: $350,000
car (fair market value): 40,000
household goods, clothing, etc.: $40,000
retirement savings: $45,000
TOTAL ASSETS OWNED: $477,000

At the time that the lender waived the deficiency, Bryan owed $578,000. Everything he owned was worth $477,000. This means that he was insolvent by $101,000.

Forgiven debt is considered by IRS to be like income. Bryan’s forgiven debt of $130,000 was greater than the amount of his insolvency - so it brings him back to solvency.

The forgiven debt is exempt from income tax up to the extent of the insolvency. This means that $101,000 of the $130,000 forgiven debt is exempt from income tax. The remaining $29,000 is taxable.

To find out whether you can use Insolvency to keep from paying income tax on your forgiven debt after a short sale, download the IRS’s Insolvency Worksheet.

And don’t worry too much about the end-of-2012 deadline for the Mortgage Debt Relief Forgiveness Act - because there are many other options for avoiding paying income tax on forgiven debt.

We at Seattle Short Sales, Inc., are a team of legal, tax, and real estate professionals who have joined forces. If you would like us to take a look at your situation, to see which solution works best for you, please contact us for a no-obligation, no-fee consultation - either by phoning us at 1-800-603-3525, or by filling out the contact form at the top of this page.

If you are a homeowner, and would like to learn more about short selling your home, please go to: http://seattleshortsales.com/homeowners/

If you are a real estate agent, and would like to learn about our no-fee short sale service, please go to: http://seattleshortsales.com/agents/


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