Since 2007, distressed homeowners have been able to take advantage of mortgage debt relief provisions in the federal tax code. These provisions were set to expire at midnight, December 31, 2012 as part of the “fiscal cliff” tax cuts.
The Mortgage Forgiveness Debt Relief Act was one of the biggest issues of the fiscal cliff debate. If left to expire, it would have caused the tax code to revert to its pre-2007 treatment of mortgage principal reductions or cancellations by lenders.
What this would mean for homeowners is that all principal balances forgiven by the lender (and unpaid by the homeowner) would be treated as ordinary income to the homeowner. To give an example to demonstrate the disastrousness of this policy, if a homeowner sold his home (mortgaged at $200,000) in a short sale for $100,000, even if his lender forgave him the difference, Uncle Sam wouldn’t– and he would be taxed on the $100,000 the bank didn’t make him pay.
Luckily, Congress has extended the relief through the end of the 2013 calendar year. For at least one more year, homeowners may “exclude debt forgiven on their qualified principal residence up to $2 million ($1 million for a married person filing separately).”
There’s no way to know whether Congress will continue to renew this Act, so if you are in a distressed or underwater position with your mortgage, you may want to consider a short sale now rather than a foreclosure and a hefty tax bill later.
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