Several weeks ago, Sheri Kamikow, Broker, CRS, Foreclosure Specialist, shared with us the major considerations in buying a foreclosed property. But what if you are on the other side of that transaction?
In today's distressed economy, whether it's due to falling values or inability to pay the mortgage, many homeowners are losing their homes to foreclosure, selling their residences in a short sale, or best case scenario, restructuring their loans with their lenders. In any of these cases, the IRS says that you have income from cancellation of indebtedness. Talk about kicking a person when they are down.
Fortunately, Congress recognized during the housing and mortgage crisis of 2007 that taxing homeowners on their debt relief was like throwing salt on the wound and would actually hinder the restructuring of home loans. Accordingly, it passed a law allowing homeowners to exclude up to $2 million of cancellation of debt income as long as the debt is qualified principal residence debt, i.e., debt incurred to purchase, construct, or improve the principal residence. The exclusion applies only to principal residences (no second or vacation homes) and is available for debt that is discharged after January 1, 2007, and before January 1, 2013.
Of course, what the government giveth, it also taketh away. To the extent you keep your property with a restructured debt, the cancellation of debt that is excluded from income reduces the basis in your residence, potentially resulting in a larger gain when you sell the property. However, that additional gain will still qualify for the $250,000 ($500,000 for joint) exclusion of gain on the sale of a principal residence.
The majority of residential mortgages are recourse which means that in a foreclosure or short sale, the lender has the right to chase you if the proceeds from sale are insufficient to pay off the mortgage. In these situations, the transaction can result partially in cancellation of debt income and partially in gain or loss from the sale of the residence. The rules are different if the mortgage is non-recourse, and the computations can be complicated in either case.
Losing your residence or having to restructure your debt can be very traumatic. Fortunately, we can help you make sure the tax bite doesn't make it any worse than it already is.
In my next post, I will cover the special cancellation of debt rules that apply where the property involved is not a principal residence. In the meantime, if you have questions about how to handle any of the issues I have described above and the potential tax repercussions, feel free to contact me at 312-670-7444.
Please visit the ORBA Blog, Connections for Success for more information about this and other topics
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