Under present legislation, any debt forgiven by a lender in a short sale, loan modification, or foreclosure is exempt from federal taxation. However, this exemption is scheduled to expire Jan. 1, 2013.
If the government allow the currently exemption to expire, borrowers will have to count mortgage relief from lenders as income on their federal tax returns, That means, for example, a borrower would have to pay taxes on a $100,000 reduction in principal owed on a loan, or taxes on a $20,000 write-off in the amount owed after a short sale.
Hopefully, an extension of the tax exemption – established under the Mortgage Forgiveness Debt Relief Act of 2007 – is a strong possibility.
However, given that Congress now has to grapple with serious fiscal issues with the election now behind us, there is no guarantee the exemption will emerge from those negotiations intact.
The Debt Relief Act exemption applies only to canceled mortgage debt used to buy, build, or improve a primary residence, not a second home. The maximum exemption is $2 million. Reinstating the tax would undercut the the effect of the National Mortgage Settlement reached earlier this year in the federal government’s investigation into banks’ mishandling of foreclosure documents.
Under the terms of the settlement, five of the biggest mortgage lenders must put some $17 billion toward debt relief that enables borrowers to stay in their homes. Smaller portions are reserved for short sales and refinancing. Even so, there will still be many borrowers who will still find themselves doing a short sale or being foreclosed upon.
Hopefully both the Federal and State governments can pass the necessary legislation to extend so families don’t end up with a large tax bill on top of loosing their family home.