While California's housing market struggles to come back from the dead, many homeowners are finding themselves with very few options. In an effort to avoid personal bankruptcy, and after unsuccessfully trying to sell their homes, they negotiate with the lenders and decide to do a short sale. Many people end up selling for hundreds of thousands less than what they owe on the home.
But homeowners may want to keep in mind that, before the housing market went into its downward spiral, "forgiven debt" on home mortgages was taxed as if it were income. For example, if you sold your house in a short sale for $100,000 less than you owed, you technically generated $100,000 in income, because it was a debt you no longer had to pay. In short, that income could be taxed.
However, the Mortgage Forgiveness Debt Relief Act of 2007 was passed to prevent struggling Californians from owing money to the IRS after losing their homes. But now, the bill is set to expire on Dec. 31. Since it's an election year, few people expect action from Congress to save the bill.
Still, if the act is renewed in 2013 or 2014, not all homeowners are eligible. The act works only with respect to your original mortgage or to a refinance for home improvement. Anyone who used a cash-out refinance or used the funds for anything that wasn't related to home improvement may still be taxed for forgiven debt.
And that is why some homeowners are opting to do a short sale now rather than wait to see how Congress acts, if at all.
Anyone who is confronting these decisions should be aware of what legal paths are available. When a person is facing foreclosure, or if mortgage debt is out of control, then there may still be options for negotiating with a lender in order to keep the home out of foreclosure. To be successful, those negotiations may require a third party with legal experience in foreclosure assistance.
Source: San Francisco Gate, "Clock ticking on forgiven-debt tax," Carolyn Said, Sept. 17, 2012