As you remember from my previous posts, there is a federal law that forgives debt in a situation of a principal reduction or short sale.
Some background: Typically a short sale occurs when the property is no longer worth the amount that the lender is suing you in foreclosure for. (ie you are being sued for $300,000 and your home is only currently worth $150,000). In this case, you wish to sell the property and think you can do so for around $150,000. You, or your lawyer, will be asking the bank for forgiveness off the debt above the $150,000 in our example, thus releasing you from any money liability to your lender and “walking away clean.”
But there is an issue with this. What happens to that forgiveness in terms of your taxes? Usually, forgiveness of any type of debt is considered income to you, and thus taxable. In our example above, the homeowner would be liable for taxes on $150,000 in extra income. This means if you make a yearly salary of $50,000, next year you would be taxed on $200,000 in total income, and at a much higher tax bracket.
The Mortgage Forgiveness Debt Relief Act of 2007 was made to address this issue Act stated that in the case of debt forgiveness for a primary residence, this income would NOT be taxable. thus, in our example above, the $150,000 would to be taxable and would vanish “into thin air.”
The same applies if you got a reduction of principal in your loan modification. The amount of principal reduced would vanish and not be taxable. If the Act is not extended, this would be additional income to you in that year and drive you into a much higher tax bracket.
There has been little to no mention of this Act to date, which is set to expire December 31, 2013. In the wake of a near-collapse of the economy, the debt ceiling, government worker furloughs and other crises. I do not see this Act being renewed again. There has been no talk in the news or coming out of the capital on this issue, despite the Act expiring in 58 days.