How Do I Qualify For The Debt Relief Act?

By Patricia Leung

Note: This article is part 1 of 2 and focuses on the tax consequences of foreclosure / short sale for homeowners. Part 2 will discuss the tax consequence of foreclosure / short sale for real estate investors.

Today’s housing market downturn has caused many homeowners to either face foreclosure or short sale of their homes. As if losing all previously built-up equity and the initial down payment (if any) was not bad enough, homeowners may also be hit with unanticipated taxes.

The IRS historically considers loan forgiveness either partially or in full by a lender to be taxable income to the homeowner. This is known as cancellation of debt (COD) income. Situations that could give rise to COD income include foreclosures, deed in lieu of foreclosure, short sales, and a reduction in the loan principal and/or interest rate.

However, an individual who meets the criteria under the Mortgage Forgiveness Debt Relief Act of 2007 may exclude COD income from taxable income.

To qualify for the tax relief, the property must be the homeowner’s primary residence. This new Act does not apply to debt forgiveness on vacation homes, rental properties, credit card loans, student loans, or car loans. However, different types of tax relief may be available in these situations, which will be discussed in Part 2.

The tax relief applies only to the original purchase price plus costs of improvements of the homeowner’s principal residence. It does not apply to debt discharges for second mortgages, home equity loans, or cash taken out during a refinance, unless the loan proceeds were used to acquire, construct, or substantially improve the taxpayer’s home. The maximum amount of relief is generally limited to $2 million.

It is also important to note that if an individual has refinanced his mortgage loan, there could be additional tax and legal ramifications. He will now have two tax calculations: one for COD income and the other for capital gains income.

For example, Iam Brooke bought her house for $100K, then refinanced and took cash out when her property value went up. She did not use this fund to improve her house. Her refinanced loan is now $500K. With the market downturn, her house is now worth only $250K and she has to foreclose on her home.

Iam will have total COD income of $250K (loan balance of $500K less fair market value of $250K). Of this amount, only $100K may be excluded from taxable income under the new Act. The remaining $150K of COD income will be taxed at her ordinary income tax rate unless Iam declares bankruptcy or is insolvent, meaning her liabilities exceed her assets’ fair market value. This determination would be made at the time of the foreclosure or short sale occurrence.

Aside from COD income, Iam will also have capital gains income of $150K (fair market value of $250K less purchase price of $100K). Fortunately, the $150K capital gains may be excluded under IRC Section 121 home gain exclusion provision.

Since this article is focused on the tax ramifications, the legal consequences will not be discussed. Please consult a qualify real estate attorney for additional information.

Once a foreclosure or short sale transaction is completed, the lender will issue a Form 1099-C for cancellation of debt or Form 1099-A for foreclosure. Homeowners should pay special attention to the amount of debt forgiven and the fair market value listed for their home. Should the homeowner disagree with any of these amounts, he should contact the lender and request a corrected Form 1099.

To claim this tax relief, homeowners must attach a completed Form 982 to their federal income tax return. At the time of this writing, California has not adopted this new federal Act. However, a pending CA bill would conform to the federal Act. Unlike the federal Act, which is valid for debt forgiven from 2007 through 2009, the CA bill applies to debt relief in 2008 only.

It is highly recommended that homeowners who are undergoing or anticipating foreclosure or short sale seek professional help from qualified tax and legal advisors. This article is provided for informational purposes only and may not be relied upon as tax or legal advice.