Congress Heaps Uncertainty on Financially Troubled Home Owners’ Misery

Unless Congress extends the forgiven debt exemption, financially troubled home owners who short sell their homes to avoid foreclosure or otherwise have mortgages forgiven will get slammed with a huge tax bill in 2013.

The nation’s attorneys general worked hard to get the five biggest mortgage servicers to agree to a $25 billion settlement to help the nation’s financially troubled home owners avoid foreclosure.

The national mortgage settlement was intended to help stop the housing market spiral and hold the banks accountable for foreclosure abuses.

Now, a good portion of that money may end up in Uncle Sam’s bank account, wrenched from the depleted pocketbooks of those same troubled home owners in the form of income taxes.

The tax rub occurs because IRS rules say a debt you get to walk away from is really income, which as you know, is taxable. 

Here’s an example of how you could get taxed on a short sale, where you sell your home for less than you owe on the mortgage:

Say you have a $100,000 mortgage on your house. You short sell your house and net $75,000 after sales expenses. You repay your lender that $75,000, creating $25,000 in forgiven debt.

The IRS will add that $25,000 to your taxable income. So if you have no deductions and you’re in a 28% tax bracket, you’d owe $7,000 ($25,000 x 0.28) in tax on that forgiven debt.

Up until the end of this year, you can escape that forgiven debt tax because Congress created an exemption for you back in 2009. Unfortunately, that exemption expires at the end of 2012.

If you qualify for a foreclosure avoidance program, like a short sale (or any of the other ways that reduce what you owe, below), but you can’t close your deal until 2013, you could face a huge tax bill. A tax bill large enough to put you right back into another financial tailspin.

Principal reduction
: The lender shaves off a specific amount from what you owe on your mortgage.

Recasted mortgage: If the lender reduces what you owe overall to lower your monthly payment, that reduction would count as forgiven debt.

Second mortgage waivers: The bank says you no longer have to repay your second mortgage and just wipes out that loan.

Foreclosure: You’d be taxed on whatever is left on the mortgage that you didn’t pay.

Finally, any time you find yourself in a cash-out situation, such as a home equity line of credit, exercise care, because not all of it will be necessarily forgiven.

There’s not a soul in Congress who’s opposed to extending the forgiven debt exemption, but it still might not happen. With the federal budget in full-on crisis mode, any legislation that concerns a tax issue faces an uphill battle.

But wait. It gets worse. Traditionally, Congress lumps all the expiring tax provisions into a single bill. That bill is among the last things Congress passes before it goes home in December. That means the odds of Congress passing the forgiven debt extension by itself aren’t good. In the last 15 years, Congress has never passed a bill extending only one expiring tax provision.

Going through the foreclosure process is incredibly stressful, even if things work out OK in the end. Having to sell your home because you can’t afford it anymore is devastating. Having the IRS send you a tax bill for the forgiven debt? That’s just cruel.