An Expiring Tax Cut that matters to Underwater Homeowners

There is lots of talk about expiring tax cuts; Bush tax cuts, payroll tax cuts but there is an expiring tax provision no one seems to be talking about, the tax provision that exempts unpaid mortgage arrears on primary residences that are subject to foreclosure, short sale or debt forgiveness.

One of the things I remember from my Income Tax course in law school is that the definition of “income” in the tax code is very broad and this is an important concept. “Income” according to the tax code includes a great deal of things you wouldn’t consider namely “discharge of indebtedness” income (11 U.S.C Sec. 61 (a) (12)). In general, under the tax code, taxpayers must include amounts representing discharge of indebtedness in their gross income.

Yes, you read that correctly, if a creditor forgives debt or you do not pay it then you have income equal to the amount of the forgiven debt and tax is due at your ordinary income tax rate. Now you may say, “but I didn’t get the money!” It really doesn’t matter according tax code. The only exceptions are a complex insolvency calculation or the filing of a bankruptcy case and the entry of a discharge. That was until Congress passed the “The Mortgage Debt Relief Act of 2007”.

This law allows an exception to income for debt discharged or forgiven as part of a foreclosure or short sale of the taxpayer’s primary residence. The problem? The exception only covers debt forgiven in the tax years from 2007 until 2012.

Many homeowners are now being offered significant reductions in principle. A good example is the Bank of America program that is provided write downs in excess of One Hundred Thousand ($100,000.00) Dollars to underwater homeowners.

If this tax provision is not extended the old rule will apply and taxpayers will be exposed to ordinary income tax on amounts forgiven or unpaid upon the foreclosure or short sale of a primary residence unless the taxpayer is insolvent or files a bankruptcy case and gets a discharge. This law has helped many underwater homeowners walk away after returning homes to the mortgage lender or selling for less than they owe. It might be time to talk about this expiring tax provision.

Ken Gogel