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If you owe a debt to someone else and they cancel or forgive that debt, the cancelled amount may be taxable.

Cancelled or forgiven debts happen every day in the Real Estate world. Short sales and foreclosures result in substantial, cancelled or forgiven debts. The Bank’s loss may be considered the home owner’s gain – a taxable, forgiven debt. A short sale happens when the proceeds of a home sale are not enough to pay off the mortgage. The bank agrees to take a “short” payoff and may cancel or forgive the shortage.

For the last 5 years, most homeowners were exempt from paying taxes on that forgiven or cancelled debt. Unless Congress acts soon, homeowners will have to start paying income taxes on that debt.

Taxable Income

If you owe $200,000 on your home but your sale only results in $150,000 in proceeds, you will be “short” by $50,000. You would likely need to count that $50,000 as taxable income to the IRS! In this case, you might owe and additional $12,500 in tax liability. In fact, you may owe this tax even if your house is foreclosed if it results in a shortfall to the bank.

Mortgage Forgiveness Debt Relief Act of 2007

The Mortgage Forgiveness Debt Relief Act of 2007 exempts many home owners from paying taxes on the forgiven debt. This law, however, is set to expire at the end of 2012. If it does, it may have a chilling effect on short sales and loan modifications. Many experts and commentators believe Congress will extend the law. It was originally effective until 2009 and Congress extended it to 2012 as part of the Emergency Economic Stabilization Act of 2008. In August, the Senate Finance committee approved a one-year extension, with bipartisan support (this was not a full vote of Congress). Others are more skeptical. A lame-duck Congress has its plate full with the looming “Fiscal Cliff.”

If the law is not extended, many believe the Real Estate market will suffer. Indeed, over 20% of Dane County sales are distressed property sales. These distressed sellers would be faced with another, “phantom” tax just to walk away from their homes.

 

 

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