During the mortgage meltdown that caused the Great Recession a decade ago, some homeowners lost their homes to foreclosure or constructed a short sale to get out from under the debt. In most cases, the lenders forgave all or part of the debt owed them.
Similarly, in the early '90s, after the Savings & Loans crisis in the U.S., thousands of homeowners lost their homes in the same way, but back then, the policy of the IRS was to consider the forgiven debt as income. Today, it is still considered income. Meaning that a homeowner could lose their home because they can't afford to pay for it, and to make matters worse, they would owe income tax on the debt relieved.
The good news is that in 2007, Congress passed the Mortgage Forgiveness Act, which continued to be extended. Currently, the expiration date for the Mortgage Forgiveness Act is 12/31/20.
The amount forgiven for income tax purposes may not be the same amount owed to the lender. Mortgage forgiveness has a limited exclusion for discharged home mortgage debt for a principal residence; it does not include second homes or investment properties. Only the amount of mortgage debt that can be treated as acquisition indebtedness in included. Below is an example to consider:
This example shows that a homeowner purchased a home and refinanced five years later at 80% of the market value. They used the new loan proceeds to pay off the original mortgage and make $30,000 of new capital improvements. The revised acquisition debt is the acquisition debt at the time of refinancing plus the capital improvements made with the loan proceeds.
The new $400,000 loan produced $39,417 of home equity debt, which is not considered acquisition debt. Home equity debt is money borrowed on a home and used for any purpose, but it may not be tax-deductible or considered acquisition debt. Acquisition debt is money borrowed to buy, build, or improve a principal residence subject to a $750,000 limit.
Assume that the borrower never made a payment on the new loan. If the new loan went through foreclosure while the Mortgage Forgiveness Relief Act is in effect, the forgiveness would be limited to the acquisition debt of $360,583. The remaining amount of $39,417 would be considered income and subject to tax.
This article is meant to inform homeowners of liabilities associated with foreclosures and possible remedies that may be available. This example illustrates the portion of a loan that could be forgiven. Taxpayers should always consult their tax professional regarding their specific situation and how the law would apply to their situation. For more information, see IRS Publication 4681.