When borrowers obtain a loan to purchase their primary residence, the loan funds are not taxable to the borrower because there is an obligation to repay the money. Prior to 2007, if the lender canceled or forgave the debt, the amount of debt that was forgiven was treated as income to the borrower, and with some exceptions, was taxable. During the financial crisis, however, Congress passed the Mortgage Debt Relief Act of 2007 (“the Act”), in order to give relief to certain taxpayers who found themselves underwater on their primary residential mortgage. Under that law, up to $2 million of forgiven debt could be excluded as income, provided the debt was originally used to buy, build, or substantially improve the borrower’s principal residence, or to refinance debt previously incurred for those purposes. This benefit applied to debt forgiven through loan modifications, short sales, deeds in lieu, and foreclosures.
For example, assume an underwater homeowner owed $450,000 for his/her primary residence but got the lender to forgive $150,000 of debt in order to short sell the property for $300,000. Under the Act, that $150,000 of debt forgiveness was not taxable.
So far, Congress has made no attempt to extend the law into 2104 and beyond. Under the above example, income tax will now be due on the $150,000 of forgiven debt. This poses a serious problem for those who waited to short sale their property, as homeowners who complete a short sale in 2014 may soon discover that they have a significant unexpected tax liability. Additionally, the number of real estate transactions in 2014 and beyond could be affected, as a significant volume of real estate transactions over the last six years were attributable to short sales and foreclosures.
If you are thinking about selling your property or have any real estate questions we welcome the opportunity to meet with you.