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Losing a home? A tax bite may be next

January 10th, 2010 11:00 AM by Lehel S.

Losing a home? A tax bite may be next

You might avoid debt-relief taxes if your lender forecloses on your house and cancels your mortgage. But you could still wind up owing a lot of money to the IRS.

By Jeff Schnepper
MSN Money

U.S. foreclosure filings have soared in recent years. In 2009, RealtyTrac estimates, 3.9 million foreclosure notices were sent to American homeowners unable to make their payments, up nearly 22% from 2008.

It's a terrible problem, emotionally wrenching for many families. And, as if losing your home isn't bad enough, you may also get slammed by the U.S. tax code. Here's where the hit could hurt and how to minimize the pain.

Debt relief and a tax break

The basic tax rule on debt discharge is simple: If a lender cancels your debt, that's taxable income to you, and you and the Internal Revenue Service will get a 1099-C form, and you will have to pay tax on that forgiveness.

But Congress gave homeowners a big gift with the Mortgage Forgiveness Debt Relief Act of 2007. It excludes as much as $2 million in debt relief from income taxes through 2012.

It applies, however, only to debt on primary residences. If you had a mortgage canceled on your vacation beach condo, you could get stuck. And you'll still have to pay tax on relief from auto loans, credit cards and similar debts.

I like this law conceptually, but I would have capped the tax-free debt discharge at no more than $250,000. Frankly, if you had qualified for a $2 million mortgage, you should have managed your finances more carefully.

Those borrowing $2 million for a home are more likely than not in the 35% income tax bracket -- meaning that a discharge costs the rest of us up to $700,000 in taxes that we have to make up.

 
There are two other exceptions that can affect homeowners:

First, if your mortgage -- even the mortgage on your beach condo -- is discharged in a bankruptcy, none of the debt cancellation is taxable.

There's a trickier issue if you can prove you are insolvent when you get a debt forgiven.

Let's say you have $120,000 in liabilities and $100,000 in assets. You're insolvent to the extent of $20,000. So, up to $20,000 in debt-discharge income would escape taxes. Any excess would be taxable as ordinary income.

Here's how it'll hurt: Let's say you have a $90,000 mortgage and $30,000 in credit card debt, and the credit card companies forgive all of that $30,000. But that's $10,000 more than you're allowed, and you'll have to pay tax on that amount.

Loss of property-tax and interest deductions

There's no escaping these potential problems. So if you think you may be losing your home, you need to adjust your tax planning.

If you lose your house, you also lose future itemized deductions for interest and real-estate taxes. You can deduct the interest on as much as $1 million in principal borrowed to acquire a home, plus the interest on an additional $100,000 in home equity borrowing. There's no limit on the deduction for real-estate taxes.

If you're paying $12,000 a year in interest plus an additional $8,000 in property taxes, that's $20,000 in deductions you've just lost. In you're in the 25% bracket, that's an additional $5,000 you will have to pay in tax. If you couldn't even pay your mortgage, getting $5,000 more for the IRS is going to be difficult.

The hit from homebuyer credits

The Housing and Economic Recovery Act of 2008 gave first-time homebuyers a refundable credit of 10% of the purchase price, up to $7,500. It was an interest-free loan from the IRS that had to be paid back over 15 years, starting with 2010.

The American Recovery and Reinvestment Act of 2009 upped the ante to as much as $8,000 that never has to be repaid -- if you stay in the home at least three years.

In both cases, you'd qualify as a first-time homebuyer if neither you nor your spouse had had an ownership interest in a principal residence in the previous three years.

If you didn't qualify for the first-time-homebuyer credit, you might qualify for a $6,500 credit. This applies to so-called move-up buyers -- those who have owned and lived in their current home for a consecutive five out of the past eight years. The credit does have income limits: $125,000 for singles, $225,000 for married taxpayers filing jointly.

But if your home were foreclosed on within 15 years (for a home bought in 2008) or within three years (for a home bought in 2009 or early 2010), it would cease to be your principal residence. The credits would have to be repaid.

Remember the extra $5,000 that your taxes went up when you lost your deductions in the earlier example? If you lost your $8,000 homebuyer credit, too, you'd have to find an additional $13,000 for Uncle Sam on top of your normal taxes.

(I'm not sure I should mention this: If you qualify as a first-time homebuyer and didn't buy a house in 2009, start shopping. If you can sign a contract by April 30, 2010, and close by June 30, you can still get the 2009 credit. But please make sure you can make the payments.)

State and local tax problems

Lastly, don't neglect the effect of the foreclosure on state and local taxes. For example, property owners in New Jersey can deduct as much as $10,000 in real-estate taxes from their state tax returns. If you lose your home, you lose that deduction as well.
Posted in:General
Posted by Lehel S. on January 10th, 2010 11:00 AM

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