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