Mortgage Forgiveness Income Tax
Millions of people are afraid they will owe income tax on phantom income that results when they either lose their house in foreclosure, or when they do a short sale.
This article explains why you probably have nothing to worry about, at least as far as the IRS is concerned. As always you need to get tax advice only from your own qualified tax advisor.
Let's start with the simple fact that when you borrow money, the money you borrow is not income. You have to pay it back. So whatever you charge on a credit card, or whatever you borrow on a mortgage, is borrowed money that must get paid back. Not income. Clear? Good.
Now, let's continue and say that you borrow money and then the lender says "no, you aren't going to pay this back."
Now that money you borrowed is no longer owed. So it becomes, in the government's eyes, income to you.
And you owe income tax on income, right?
So a lot of folks have stressed out and worried that they owe income tax on the amount of their mortgage that they didn't pay. Let's use an example.
If your mortgage was $300,000 but you did a short sale for $200,000, then you have $100,000 in income that the IRS calls cancellation of indebtedness income.
If your tax rate is 30%, you would owe $30,000 on top of having this awful foreclosure or short sale on your credit report.
However, the way the law has read, there are two exceptions. One exception says that if you are insolvent at the time you get this cancellation of indebtedness income, then you owe no tax.
What does insolvent mean? It means if you add up all your assets such as cash and the value of your house (but excluding many retirement funds), and you subtract all your liabilities such as your mortgage and the amount you owe on your other loans, then you end up with a negative number. You owe more than you have. You are technically insolvent.
So you have no tax liability.
Also, if the mortgage is non-recourse, then you have no tax liability. So for many states such as California, loans used to purchase a primary residence are non-recourse and therefore, for these purchase money mortgages, there is no liability for cancellation of debt.
And there is now a new law that Congress passed and President George W. Bush just signed, H.R. 3648, The Mortgage Forgiveness Debt Relief Act of 2007. That Act says two things. First, that the insolvency test is no longer the only test that says whether or not you have cancellation of debt income tax liability.
Now, you do not have cancellation of debt income tax liability if do a short sale or a foreclosure, so long as the house is your principal residence and the amount of cancellation of debt does not exceed $2 million.
For investors, the insolvency loophole will continue to be critical because they may have houses and properties that they lose in foreclosure and because they are insolvent, they can avoid federal tax liability for cancellation of indebtedness.
This law is welcome but will not have much affect because most people already could escape federal tax liability based upon the insolvency test. And it does not affect investment property. However, every little bit helps.
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22 Comments on Mortgage Forgiveness Income Tax »
Beverly Dwyer @ 3:38 pm:
Question: Under the new law, what happens if a second house was purchased with the intent of being the principal residence; however, due to health issues the move never took place and it was never rented? Now, the property is available for sale or short sale.
Richard Geller @ 3:47 pm:
For tax purposes there is cancellation of debt income unless:
1. you are insolvent (your liabilities are greater than your assets), or
2. this is your principal residence, or
3. it's a non-recourse loan
Most people in this situation owe so much that their liabilities are greater than their assets, so they are "technically insolvent" and therefore have no federal tax liability for cancellation of debt income.
Emma @ 5:24 pm:
HI,
I have received a 1099c from the foreclosure of a property (house mortgage). We did live in the house for a time. How do I know if my loan was a non-recourse loan or not? What do I do with the 1099c if I dont report it on my taxes and pay income tax on the balance? Do I have to report it at all?
david @ 12:26 am:
How do I determine insolvency if I have rental property that for 2 years homestead in florida. Now I live in Georgia. I owe 169,900 and my assests are about 10,000 IRA's do they use the origianl amount of the loan or the amount forgiven for debts Is it better to do a short sale, deed in lieu or foreclosure
Your net worth is what determines solvency. Add up your assets. Subtract what you owe. Include in assets things like house values. Include in what you owe the mortgages. If it is a negative number, you are insolvent to that extent.
warmly
–Richard
MAry @ 9:45 pm:
Like the writer above indicated. When you recieve the 1099c what are you supposed to do?. Is there a way to determine insolvency? Is this done through an attorney or a tax accountant. Do you contact the IRS or what. Kindly explain the process of satisfying the burden of proos as being insolvent. MAry
The answer is a bit complicated. The IRS is NEVER a good idea. Contact an accountant and pay for an hour or so of his or her time. PLEASE don't get tax advice from the IRS!
Insolvency is basically simple. Add up everything you owed at the time of the cancellation of debt (the deed in lieu or foreclosure sale or short sale), and add up all your assets at that time (including the value of the property that was lost) and the number should be negative. That is the extent of your negative net worth. But things like qualified retirement accounts MAY have to be included, and there is complexity if you got cash out from refis, so this is something left to an expert.
warmly
–Richard
David @ 11:47 pm:
I am underwater on my second home, which I also rent out part-time (ski rentals). I would love to walk away or short sell, but I am afraid I will then have to pay considerable gains taxes, even if I get a short sale approved (I bought it cheap in 1999, and refied for 5x orig value in 2007). I have considerable assets in my principal home and other cash assets, and my principal VA home is also for sale — hopefully I will use my IRS gains "forgiveness" when that house sells. The second home is in PA, principal residence in VA. Is there any way to avoid paying huge gains taxes if I short sell? Walk away? And, I guess the bank WILL come after my other assets if I walk away?
Jon @ 3:23 pm:
I Live in California and have a condo that I am upside down on. I am honestly intending on buying a new home and renting out the condo until things pick back up. I am however afraid that after I buy the new home if anything goes wrong I might have to let go the condo and am worried about tax issues. I would not qualify as insolvent. Assuming this is a non disclosure loan and that it was purchased as a primary residence does it matter that it would have been converted into rental property. I have read that rental property is not exempt from taxes..or have I misunderstood and that it is rental property that was purchased as such that has the tax issues and not converted properties.
Thanks
Roberta Kelly @ 10:19 am:
Hi: I bought a house and lived in it for about 2 months when my financial situation changed drastically. I lost the overtime I had used to qualify for the house. The house is up for short sale right now and we're waiting for the bank to either accept or deny it. My question is: With overtime, I'm not insolvent, but without it, I am. Since there is NO GUARANTEE of overtime anymore, even if I have some occasional OT, can they count that toward the insolvency test?
Insolvency has nothing to do with income. It has to do with a simple formula (although there are details such as qualified retirement plans that I can't get into):
assets (everything you own)
minus
liabilities (everything you OWE)
equals
net worth (positive or negative)
If your house is a short sale, that means you owe MORE than it is worth. If you do not have any other significant assets, then you have a negative net worth and are therefore technically insolvent. Regardless of income.
warmly
–Richard
Dan @ 9:57 pm:
How do I know whether I have no-recourse loan or not?
andrew @ 12:36 pm:
regarding insolovency test. I've two rental homes ($200,000 underwater), a main home ($60,000 positive equity) and about $150k (401k, IRAs) in retirement accounts. Am I insolvent? if so, by how much?
Chell @ 10:40 am:
thank u this web site have been most helpful to me.
grace @ 3:47 pm:
in determing insolvency. do i list the fmv of the house that was sold in short sale and which incidentally result in debt forgiven and a 1099c given?
here's the situation…my second home that i coborrowed with a friend( i didnt stay there i had my own home). the second home was sold at 99k and amount forgiven was 107k in 1099c. in listing my assets and liabilities to determine insolvency, do i list the fmv of home which is 99k as one my assets and 210k as one of my debts?
Rick C @ 11:13 pm:
In determining insolvency, do I have to count my 401k as an asset. Currently, I have my primary residence which I owe 390k and a rental property which I am selling short for a loss of 100K. The fair market value of the rental property is 285 which would still leave my about a 100k short. So, when I add both houses as asset that gives me 665K, correct. so, do i now need to add my 401 k which i have about 140K?
Arty @ 4:31 pm:
When you find out how to determine if your loan is a non-recourse or not, would you let me know how and what to look for so I can see if my loan is a non-recourse or not. Thanks Arty from Florida
Arty @ 4:32 pm:
Hi would you let me know how to tell if my mortgage is a non-recouse loan or not-Thanks,Arty from FL.
Woniya @ 7:19 pm:
Hello,
You say that the Debt Forgiveness act is one way out, but aren't banks sort of keeping that as a leverage? After 2012, even one day into the new 2013 year, you'd be liable for the tax difference if you lost or walked away from your home.
Another question, doesn't the insolvency issue only relate to Federal taxes? Won't the state come after you as well?
Thanks, WW, Bay Area, California
Craig @ 9:54 am:
Hi Richard - I was at first very pumped up when you said that retirement funds don't count toward insolvency calculation, but I can't find anywhere on the IRS website where it doesn't say that 401k, IRAs, pensions, etc. are all includable on the asset side. Here is what has take the air out of my balloon directly from the following website:
http://www.irs.gov/publications/p4681/ch01.html#en_US_2010_publink1000244090
Insolvency
Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation. For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of your retirement account). Liabilities include:
The entire amount of recourse debts,
The amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt, and
The amount of nonrecourse debt in excess of the FMV of the property subject to the nonrecourse debt to the extent nonrecourse debt in excess of the FMV of the property subject to the debt is forgiven.
Kim @ 2:55 am:
I own two properties in CA. Both are underwater. In the last 5 yrs, I lived in the Condo for 3 yrs and the House for 2 yrs.
Can I can receive debt forgiveness on both properties in 2011 & 2012?
My plan is to short sale the Condo this year (2011). I owe 312k and it's worth 250k. I bought it 15 yrs ago and it has been refinanced. I would be liable for 62k cancellation of debt.
Then, I will probably need to short sale the House in 2012, since all my Loans are adjustable. I've been using the HELOC to make the mortgage payments.
I owe 445k on the 1st and 125k on the 2nd. Home is worth 475k.
I'm hoping I can use the Mortgage Forgiveness Act for both properties since they were both my Principal Residence during the last 5 yrs. Please advise.
Thank you so much.
Shelly @ 4:20 am:
My home is currently worth 100 thousand less than what I paid. I'm ready to walk. I live in Washington State (non recourse I believe?). My question is I have a small business that barely makes it and I am partners in another busines that used to be a trust but is now dissolved. The partnership remains andis commercial property that I receive an income off of. Can the bank come after that or put a lien on the commercial property i'm partners with? Thank you for your help, Shelly
Crystal VA @ 3:55 pm:
my primary home foreclosed Oct 2008 on 1st mortgage… now, 8/2011, I am getting Collection agency notices for the balance of my 2nd mortgage.
I have no assets left , am retired on a pension and renting.
Do they have the right to contact me and do I contact them???
kel @ 1:36 pm:
Hello, and thank you for this site. I saved for 20 years on my teacher salary to buy my first home. In five years, my health has gone south, the town is bankrupt (Vallejo, California) crime is up. Two drug houses on the block are bringing in nasty types. I paid 410k. The house next door just sold for 50k. My loans are 80/20 first with BofA (via Greenstreet and then Countrywide–Country took over Green, and then BofA took Countrywide..so who knows where the original loan papers are!) The second is a purchase money HELOC with Wells and a balloon payment coming in three years I will not have. I can make payments now, but doubt it later as the house needs a ton of work that wasn't disclosed initially. As a teacher, I make less money than I did last year owing to cuts and furlough days.
QUestion is…is my HELOC for purchase recourse? ANd do I have to be freaking out that if i intend to leave this place, I'll be on the hook for the tax liability if I don't go before the 2012 deadline… Such stress. Lord, life is stressful enough without losing my lovely garden and wonderful wood floors. But I feel I need to be business minded about it all and get on with my life.
Any help appreciated.
K
T @ 9:15 am:
What about HELOC's on principle residences? If you settle a HELOC with a balance of $100,000 for $10,000 are you responsible for income tax on $90,000? Can you use the "insolvency rule" for HELOC's?
Thank you,
T