Rancho Santa Margarita Homes & Lifestyles

Good news for many distressed home owners who are upside-down in their homes!

H.R. 3648 has been signed into law by President Bush. The primary purpose of this bill is to temporarily provide relief to financially-devastated home owners by shielding them from the additional burden of potential federal income tax on any amount written off or forgiven by their lender in case of foreclosure or short sale. The law protects taxpayers who have lost, or will lose, their qualified primary residence via foreclosure or short sale during the period of January 1, 2007 through December 31, 2009.

The tax code treats debt relief or cancellation of debt from a lender as income, taxable at ordinary income rates. The amount of debt forgiveness is reported on a 1099, which is sent to the taxpayer and forwarded to the IRS. This applies to both recourse and non-recourse debt. If you find yourself in a position to short sale your home, or if you are in danger of losing your home to foreclosure, it is essential that you consult a qualified tax professional. For the record, I am not a tax professional. The intention of this post is not to give tax advice, but rather to share my understanding of this new legislation and how it may potentially provide hope for many struggling home sellers.

Imagine for a moment that you purchased a home for $800,000 in August of 2005 and had obtained 95% financing. You have a first trust deed for $640,000 and a second trust deed for $120,000. The market value of your home has dropped to $650,000 and you owe $110,000 more for your home than it’s currently worth. You’re not happy about the decline in home values, but you figure you can stick it out. Then the unexpected happens. You lose your job or get sick or injured, and all of a sudden you’re in a financial mess.

Before the passing of this new Bill, many who lost their homes to foreclosure or a short sale, were shocked to find themselves owing significant amounts of federal income tax. They incorrectly assumed that since they were losing money on their home, that there would be no tax implications. The IRS, as we all know, tends to see things a little differently than most of us do. And it’s usually NOT in our favor.

Let’s assume that your are doing a short sale which your lenders have approved. Your home goes into escrow and sells for $650,000. Your Lenders forgive debt for the $110,000 you were short, plus commissions and fees. For simplicity’s sake, I’ll use just the $110,000 deficit for taxation purposes. So your Lenders each issue a 1099 for the amount of debt they have agreed to forgive. When taxes are due you hand the 1099s to your CPA and are shocked to learn that you owe approximately $27,500 in additional federal income taxes.

Yikes! That’s right. Without the temporary reprieve provided by the passing of H.R. 3648, you would have been taxed on $110,000+ as ordinary income. And if you don’t have the funds to pay your federal income taxes? That’s another nightmare in itself. You’re toast!

The Mortgage Forgiveness Debt Relief Act of 2007 aims to protect distressed home owners from this exact situation. If you are about to lose your home, either through short sale or foreclosure, consult with an experienced real estate agent, and a tax professional. Know what to expect before you get there.

Additional information regarding debt forgiveness and tax ramifications can be found on the IRS website.

If you would like me to email the full handout “Taxation of Foreclosures, Deeds in Lieu of Foreclosures, and Short Sales” by the California Association of Realtors please send an email to kelly@kellykilpatrick.com.

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