New Law Eliminates Income Tax Liablity For Some Short Sales

Previous posts on this blog have discussed income tax risk associated with giving banks a deed in lieu of foreclosure or arrangements for a short sale. The general rule is that foregiveness of debt, including a bank's waiving mortgage deficiency liability, is taxable income. Last month, December, 2007, Congress passed a bill to relieve many homeowners from income tax liability associated with deeds in lieu, short sales, or foreclosure. The Mortgage Forgiveness Debt Relief Act of 2007 states that homeowners will not be subject to income tax from release from mortgages used to buy or improve their primary residence. Link: GovTrack: H.R. 3648: Text of Legislation.

The Act exempts up to $2,000,000 of debt forgiveness for married couples. Yet, not everyone is eligible for this income tax shelter. There are time limits on this legislation. The Act applies to debt forgiveness from residential mortgages from January, 2008 through December, 2009.

Only relief from mortgages on primary residences is tax protected. A debtor can still be taxed from a deed in lieu, short sale, or a foreclosure on an investment property, second home, or a business mortgage. Also, many debtors took second mortgages on their homes during the housing bubble to pay off and consolidate credit card debts. Mortgage companies often required borrowers to pay off all credit card debt with finance proceeds in order to increase their ability to pay their home mortgages. Any portion of forgiven mortgage debt used to pay credit card debts will still be subject to taxation.

Debtors whose mortgages do not qualify for this legislative relief may still escape debt forgiveness taxation by filing bankruptcy prior to the foreclosure or by filing IRS forms declaring their insolvency at the time of foreclosure.

Another interesting comment on this new law was posted by Oregon attorney Kent Anderson on the Bankruptcy Law Network Blog Link: Home Loan Foreclosure No Longer a Tax Trap? : Bankruptcy Law Network.

posted by Jonathan Alper, bankruptcy and asset protection attorney, Orlando, Florida