If you had mortgage debt forgiven in the last year by your lender, check the mail. Your lender should be sending you a 1099-C form in the mail right about now. The 1099-C lists the amount of debt your lender wrote off.
Hard as it seems to believe, struggling homeowners have had it easy for the last seven years in at least one way: The Mortgage Debt Forgiveness Relief Act gave anyone who got foreclosed on or short-sold their home a substantial tax break. Prior to 2007, the IRS considered forgiven debt as ordinary income to the debtor. The benefit of tax forgiveness was considered to be substantially the same as a cash benefit, and therefore the debtor was charged income tax on the amount of tax forgiven.
Congress passed The Mortgage Debt Forgiveness Relief Act in December of 2007, just as the Great Crash was getting going in earnest. It was a politically popular law, and naturally popular sentiment was with overextended borrowers at that time, rather than the bankers who were actually losing money!
Eligibility
Debt eligible for the exclusion was any debt used to purchase or upgrade a personal residence, secured by an interest in the residence itself. Investment property does not qualify. However, debt acquired to refinance a personal residence qualifies.
Originally, the law was set to expire at the end of 2009. But it was so popular that Congress extended it twice, before the law finally ran out of steam at the end of 2013.
At the time, honestly, Congress had little choice but to extend it. With so many out of work, and so many people losing their homes precisely because their incomes had taken a hit, with one or both spouses laid off or experiencing a substantial reduction in compensation, any income tax on substantial forgiven mortgage debt would have been uncollectible anyway.
The law expired on Dec. 31, 2013. Once again, the IRS will charge homeowners who experience the benefit of a forgiveness of all or part of their mortgage balance with income tax on the amount forgiven, except in cases of insolvency or bankruptcy.
Here’s how it works:
Generally, the IRS treats debt forgiven as equivalent to income. For example, if a borrower got in credit card trouble, and negotiated a settlement in full on his credit card debt with the issuing banks, he would also be charged income tax on any amount the balance was greater than the settlement amount.
Under the Mortgage Debt Forgiveness Relief Act, however, the tax on any amount forgiven to a homeowner was not taxed at all. The banks took the write-off, but there was never any compensatory benefit to the U.S. Treasury in terms of tax paid by the borrower.
The amount eligible for forgiveness under the MDFRA was substantial: up to $2 million for married couples ($1 million for married individuals filing separately).
In the meantime, those credit card borrowers did not enjoy the tax benefit of deductible interest payments like homeowners did, and are generally less affluent than those who were able to buy homes.
The result was a regressive subsidy of mortgage debt, with poorer borrowers in essence helping subsidize borrowing for wealthier individuals. If you had any doubt about whether homeowners and the real estate industry have some political clout in Washington, this should cure you of it.
On the other hand, a substantial tax bill that comes with a short sale on a home has a pernicious secondary effect: a severe crimping of labor mobility – a vital ingredient in economic freedom and an important part of maximizing the productivity and value of a worker’s efforts.
If a machinist in Detroit gets laid off by General Motors, while at the same time the value of his home in Detroit is gutted by, well, the fact that it’s in Detroit, he could well get a job offer from the Toyota factory in Tennessee. There’s a shortage of skilled machinists local to Tennessee. But the Detroit area has a huge surplus of machinists. If the Michigan worker can’t sell an upside-down home, or can’t manage the tax bill, then the problem begins to spill over into the public policy arena.
Despite the recent recovery in the housing market, those labor imbalances have not gone away. There are still powerful reasons why this particular tax break should be extended, despite the unfair subsidy objection.
Legislative Outlook
At the moment, there are at least two bills percolating in the House of Representatives that would extend the tax help:
H.R. 2788, sponsored by Joseph Heck (R – NV)
H.R. 2994, sponsored by Tom Reed II (R – NY)
Both bills are sponsored by Republicans, but support for this tax relief is bipartisan. The law was originally passed by a Democratic House of Representatives. Reed’s bill, the more likely candidate, actually has more Democrat sponsors (38) than Republican sponsors (32). (Heck’s bill has four Democrat cosponsors, plus Heck.)
At the moment, however, both bills are languishing in committee – and it doesn’t look like they’ll be moving forward anytime soon.
It’s looking more like 2013 was the year to get your principal cramdown or short sale done. If you are lucky enough to have mortgage debt forgiven in 2014, you may still get caught with a nasty tax bill – and one that has to be paid by April 15, 2015, plus allowable extensions, rather than one that you can spread out over many years while waiting for property to appreciate.
This could, in turn, mean that homeowners may be much less willing to engage in a short sale – which could put a crimp on the short-sale market going forward – especially as awareness of the tax issues surrounding these transactions grows.
By Jason Van Steenwyk on February 11, 2014
http://www.realestate.com/advice/reminder-short-sales-and-foreclosures-could-bring-a-nasty-tax-bill-83412/