Home Mortgage Debt Forgiveness

These days approximately one quarter of the homes in America have dropped in value to levels that are less than what the home owners owe on their mortgages. This often leaves the borrower unable to keep up the payments on the loan, which in many cases leads to the loss of the residence.

And unfortunately the loss of his residence is not necessarily the end of the former home owner’s problems. If the bank forecloses on the property, because the owner cannot make the payments, the court will order the house to be sold in an auction. In many cases the auction price will be too low to pay the balance on the mortgage, and the court will enter a judgement ordering the former homeowner to pay the bank the amount of the deficiency.

In some cases for a variety of reasons mortgage companies end up accepting less than the total balance due on the home. The home owner might enter a short sale of the property in which the mortgage company agrees to accept the sales price, after expenses, even though they will end up receiving less than the total balance due on the note. The debtor might give the mortgage company a deed in lieu of foreclosure, which allows the bank to reacquire the property without going through the lengthy foreclosure, but which also cancels all debt due under the mortgage. Or the court may not enter a judgment against the homeowner for the deficiency leaving the debtor with no legal obligation to pay the funds back.

In these case however the borrower may still not be out of the woods, because Section 108 of the Internal Revenue Code provides that cancelled indebtedness is taxable income for the debtor.

With the wave of foreclosures foreclosures  created by the recent meltdown in the housing market Congress granted some relief for mortgage debt discharged through 2012, and a homeowner who meets the qualifications of the temporary law can avoid paying tax on a forgiven mortgage debt.

The first qualification is that the mortgage must be on the taxpayer’s principal residence. A debtor cannot claim this exception for investment property or for a vacation home. In addition the exception is limited to home acquisition indebtedness up to $2,000,000 (or $1,000,000 in the case of a married individual filing separately). Acquisition indebtedness includes refinancing of home acquisition indebtedness to the extent the refinanced amount does not exceed the original indebtedness.

Example


Herman Highflyer buys a house in Libertyville, Illinois for $450.000 in 2000 putting $50,000.00 down. During the next few years the house appreciates in value, and in 2005 he takes out a home equity loan for an additional $400,000. In 2010 Herman loses his job and when he is unable to pay his mortgage the bank agrees to allow a short sale in which they accept $600,000 in settlement of the outstanding note. The $200,000 debt forgiveness will not qualify for the special rule on discharge of mortgage debt, because it exceeds Herman’s acquisition indebtedness.
There are other exceptions to the cancellation of indebtedness income though, most notable bankruptcy and insolvency, and with luck Herman will qualify for one of these exceptions and will still be able to avoid adding $200,000 to his taxable income.