Future of Mortgage Forgiveness Debt Relief Act Still on Hold
The Mortgage Forgiveness Debt Relief Act (MFDRA) expired December 31, 2013.
The Senate Finance Committee voted to approve the break for the 2014 and 2015 tax years. The House of Representatives introduced H.R.2994 – Mortgage Forgiveness Tax Relief Act of 2013 , where it is bogged down.
According to a November 2014 brief from the National Association of Realtors
…about 5.3 million homes are still under water. In addition, there are still more than 1 million homes in the process of foreclosure. If H.R. 2994 is not enacted, hundreds of thousands of American families who did the right thing by short-selling their home will have to pay income tax on phantom income
The Mortgage Forgiveness Debt Relief Act prevented homeowners who went through a short sale from being taxed on the amount of their home mortgage debt that had been forgiven. Now, debt that has been forgiven by a lender might count as taxable income.
If you are underwater on your home mortgage and need to sell your house, what do you do now?
IRS “Insolvency Clause” Offers Tax-Saving Alternative
Short sale sellers can still be exempt from tax liability under the “insolvency clause” of the Internal Revenue Code. The clause states that a seller is exempt from paying tax on any forgiven debt to the extent that they are insolvent. In other words, if the seller’s debts and liabilities exceed their assets by more than the amount of debt forgiven, they do not have to pay taxes on the forgiven debt.
Here’s an example of how the Insolvency Clause works:
A seller has a home valued at $300,000, but the mortgage debt is $400,000. We short sell the property for $300K and the bank elects to forgive the debt on the $100,000 shortfall amount. Since debt that has been forgiven counts as taxable income, the IRS would treat the $100,000 of forgiven debt as income.
This is where the insolvency clause formula comes in. Begin by adding up all of your debts/liabilities in one column and all of your assets in another. For this formula, the IRS wants you to include the mortgage debt as a liability, and the fair market value of your house as an asset. Let’s say you have $600,000 in assets and $700,000 in debts/liabilities. You are insolvent by $100,000.
Since your insolvency amount of $100,000 equals the forgiven debt amount of $100,000, it’s a wash and you will not have to pay taxes on that forgiven debt. You are shielded dollar-for-dollar on the amount of forgiven debt up to your insolvency number. Let’s say you were only insolvent by $80,000. In that case, you would still have to pay income tax on the remaining $20,000 of forgiven debt.
It is critical that homeowners considering a short sale meet with a professional to review their options and discuss the potential legal and tax implications.
Washington Property Solutions offers FREE real estate attorney consultations as part of our service.
Call us at 425-381-2233 to schedule a free confidential consultation.