Tax Upsides & Downsides of Mortgage Debt Relief

Published: April 14, 2010

Upside – Downside of Debt Forgiveness.

As you are aware, California just passed SB401 which brings the state of California into compliance with the Federal Mortgage Debt Relief Act of 2007. Essentially what that means is that, like the federal program, California homeowners who have benefited from a short-sale or foreclosure (benefited? That’s questionable), qualify for relief.

upside downMost of you already know what it means but for any first-time readers, this means if you took out a loan from a lender to buy a house and that house is now worth half what it was when you bought – you are upside down in your house. You owe more than you can sell it for.

But say you lost your job or have to relocate or the adjustable interest rate grew faster than your income and you can no longer afford your home you either have to get them to modify your loan (good luck) sell it as a short-sale (good luck), or let the bank take it back either through a foreclosure or a deed-in-lieu. Regardless, the bank is going to take a hit because they can’t recoup the amount of money they originally lent you.

Prior to the Tax Forgiveness Act, the difference between what you owe and what they end up with could be considered income because you no longer had the obligation to repay the lender. The IRS could, and did, tax that as income in the year it occurred. So if you bought a home for $400,000 and sold or lost it for $200,000, the bank would report that $200,000 differential as income and it got tacked onto whatever else you made that year and you got taxed on it – even though you never saw a penny of the cash.

Under the Mortgage Debt Relief Act, and now California SB401, you will no longer be liable for moneys used to purchase your principle residence as the result of foreclosure, short-sale or loan modification.

However, there are caveats that some folks are finding out at tax time at their own detriment. For example:

  1. If you took out a 2nd mortgage or refinanced your home and took cash out to buy toys, take a vacation or otherwise squandered the cash – you may still be on the hook.
  2. If you used a HELOC (home equity line of credit) to buy toys, take a vacation, pay for education or otherwise squandered the cash – you may still be on the hook.
  3. You used the money to buy a vacation home and lost that to foreclosure – you may still be on the hook.
  4. If the property is over $2 million dollars and you lose it. The Act covers only the first $2 mil. After that, you are on the hook..
So there are many definite benefits to the Act as well as SB401, but it doesn’t resolve all your issues. In California a lot of folks used their homes like ATM machines taking out $50 or $100k every few months during the run-up. You are still on the hook.

In addition, as noted in earlier posts, California’s SB401 is a ‘revenue neutral’ bill which means that for every dollar of forgiveness accrued to somebody, somebody else is paying a buck’s worth of new tax. If you’re not one of the ones getting tax relief, then you’re one of the ones paying more. Actually, even if you get relief you will still be paying higher taxes in other areas. And while the debt foregiveness portion of the bill sunsets in 2012 with the federal program, the other taxes go on and on and on and…

And you thought lunch was free…

More information, including detailed examples can be found in Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments. Also see IRS news release IR-2008-17.

Last modified: April 14, 2010 at 11:45 am | Originally published: April 14, 2010 at 11:45 am
Printed: September 29, 2020