After a bank forgives your mortgage debt in a short sale, your tax problems may not be over.
The Internal Revenue Service (IRS) views reduced or canceled debt as “income” and you may have to pay taxes on the amount forgiven. Since 2007, about 1.8 million U.S. homeowners have sold via pre-foreclosure sale, and most of those are short sales, according to the RealtyTrac U.S. Foreclosure Sales Report. Another 12.5 million borrowers are “underwater” on their mortgages, at higher risk for so-called strategic default.
When lenders cancel a debt of $600 or more, by law it must send you and the IRS a 1099-C tax form, entitled Cancelation of Debt, which contains information regarding the canceled debt. Under the Mortgage Debt Relief Act of 2007, if your mortgage debt on your principal residence was canceled between 2007 and 2012, the forgiven amount would not be taxable. The law only applies to primary residences, not second homes or investment property.
Here’s the key. Regrettably, the Mortgage Debt Relief Act of 2007 is set to expire on Dec, 31, 2012. Rep. Charles Rangel, D-N.Y., has introduced a bill (H.R. 4202) to extend the tax relief act. If the Mortgage Debt Relief Act is not extended, the number of bankruptcies could skyrocket after 2012. Waiting to do a short sale after 2012, a homeowner may incur serious tax penalties that they would avoid by short selling before Dec. 31, 2012.
Taxpayers are required to declare any canceled debt on their tax returns by attaching Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, to the tax return. Instructions on how to fill out the form are contained in Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments.
As always, consult with a tax professional about your specific situation. For more details about mortgage forgiveness on first and second mortgages, or a refinanced mortgage call the IRS tax assistance line at 800-829-1040. Or look to RealtyTrac for advice on foreclosed homes.