Denha & Associates, PLLC Blog


By: Lance T. Denha, Esq., Of Counsel

In recent years, most homeowners who have property worth less than the debt owed on the property, or property said to be “underwater,” or who may have lost property to a foreclosure or short sale were excused from having to pay income taxes on the difference between what was owed on the property and what was realized from a sale of that property. This “phantom income” was not taxable because of the Mortgage Debt Relief Act of 2007 (“The Act.”) The Act states that homeowners don’t have to include forgiven debt as income provided all of the following are all met:

1. The debt is secured by a principal residence. Mortgages on investment property or vacation homes don’t qualify.

2. The debt was “used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes.”

3. The maximum amount that could be treated a “qualified principal residence indebtedness” is $2 million, or $1 million if married and filing separately.

Unfortunately, for these folks, the Act’s protections are scheduled to expire at the end of this year. What is not clear is what Congress has in mind for renewing its terms. There was a suggestion by the Obama administration to extend the Act to 2014, however no clear direction has been given as of yet.

The scheduled expiration of the Act means uncertainty for many “underwater” homeowners who are currently in the process of foreclosure. More than 2 million people are currently in foreclosure, according to numbers maintained by Lender Processing Services. An additional 4 million mortgage holders are at least 30 days behind. If you fit this classification, then it’s more than likely you have received correspondence from your lender regarding loss mitigation options such as mortgage modifications, deed in lieu of foreclosure, short sales and forbearance agreements.

In contemplating loss mitigation options it is important to remember that anytime a mortgage is modified (i.e., reduced), the borrower is required to recognize cancellation of indebtedness (COD) income under Internal Revenue Code Section 61(a)(12) to the extent of the debt forgiveness. Similarly, if a property is sold at foreclosure or in a short sale and the underlying mortgage is recourse (meaning the borrower has personal responsibility for any excess loan deficiency remaining after the sale), then to the extent the remaining deficiency is forgiven, the borrower will again recognize COD income.

Additionally and also worth noting, in the foreclosure or short sale context, this same COD income is NOT treated as gain from the sale of the home, and thus is not eligible for exclusion under Internal Revenue Code Section 121, which allows married taxpayers to exclude up to $500,000 of gain on the sale of a home, provided they have owned and used the home as their principal residence for two of the prior five years. As a result, barring some sort of statutory relief, the COD income must be recognized.

Again if you are in need of this type of relief, it is highly advisable to rush to obtain relief before the new year because, as of today, this exclusion is set to expire on December 31, 2012.