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The Color of Money

As debt forgiveness tax break is set to expire, look carefully at your options

By Michelle Singletary
The Washington Post / September 25, 2011

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The time is limited for homeowners who want to ensure they aren’t hit with a big tax bill because they had to walk away from a mortgage obligation.

At the height of the housing crisis, when foreclosures across the country began a troubling increase, Congress passed the Mortgage Forgiveness Debt Relief Act of 2007, designed to provide at least some consolation to folks who had lost their homes.

But it gets complicated.

If you borrow money and the lender then cancels or forgives the debt, you generally have to include the canceled amount as income for tax purposes. As the IRS explains, you aren’t taxed on borrowed money because you have an obligation to repay it. However, if the debt is wiped out, the lender is then required to report the amount of canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.

That’s where the mortgage debt relief act comes in. It allows people to exclude income from the discharge of debt on their principal place of residence. In addition to foreclosure, debt reduced because of a mortgage restructuring also qualifies for relief under the new law.

As always, there’s a catch.

The law says that only debt forgiven in calendar years 2007 through 2012 is eligible. Up to $2 million of forgiven debt qualifies for this exclusion ($1 million if married filing separately).

To get the relief, debt must have been used to buy, build, or substantially improve a principal residence and be secured by that residence.

If you’re clinging to your house but it’s looking as though you won’t be able to hang on, the best time to get out from under the mortgage is before the debt relief law sunsets. This is particularly true if you are thinking about a short sale. That’s when the lender allows the borrower to sell the house for less than what is owed. Often, the borrower can negotiate to have the remaining balance on the mortgage forgiven.

The tax rule has become particularly important as more homes are sold through short sales, which accounted for 12 percent of all housing sales in the second quarter, up from 10 percent for the same period last year, according to RealtyTrac.

However, here’s the problem if you wait too long to start the process: Short sales are being dragged out for months. Talk to real estate professionals and many might suggest the term short sale be changed to “long sale.’’ I’ve seen several people who wanted to buy a home through a short sale walk away because the transaction was moving too slowly.

You shouldn’t rush into a short sale or let your home go to foreclosure just to avoid a tax debt. But the impending end of the favorable tax rule on forgiven mortgage debt should be one of the things to consider if you conclude you can’t afford to keep your house.

Michelle Singletary is a columnist for The Washington Post. She can be reached at singletarym@washpost.com.