For homeowners in trouble, a tough decision to make

The time is limited for homeowners who want to ensure they aren’t hit with a
big tax bill because they had to walk away from a mortgage obligation.

At the height of the housing crisis, when foreclosures across the country
began a troubling increase, Congress passed the Mortgage Forgiveness Debt Relief
Act of 2007, designed to provide at least some consolation to folks who had lost
their homes.  

But it gets complicated.

If you borrow money and the lender then cancels or forgives the debt, you
generally have to include the canceled amount as income for tax purposes. As the
IRS explains, you aren’t taxed on borrowed money because you have an obligation
to repay it. However, if the debt is wiped out, the lender is then required to
report the amount of canceled debt to you and the IRS on a Form 1099-C,
Cancellation of Debt.

You can imagine the frustration that many people had with this seemingly
unfair tax rule. They had lost their homes and then discovered in a
“you’ve-got-to-be-kidding-me” moment that they owed taxes on the forgiven

That’s where the mortgage debt relief act comes in. It allows people to
exclude income from the discharge of debt on their principal place of residence.
In addition to foreclosure, debt reduced because of a mortgage restructuring
also qualifies for relief under the new law.

As always, there’s a catch.
The law says that only debt forgiven in calendar years 2007 through 2012 is
eligible. Up to $2 million of forgiven debt qualifies for this exclusion ($1
million if married filing separately). To get the relief, debt must have been used to buy, build or substantially
improve a principal residence and be secured by that residence. So if you
refinanced and took money out of the house to pay off credit card debt, you
won’t receive the exclusion. Debt forgiven on second homes, rental property,
business property, credit cards or car loans also does not qualify for the tax

If you’re clinging to your house but it’s looking as though you won’t be able
to hang on, the best time to get out from under the mortgage is before the debt
relief law sunsets. This is particularly true if you are thinking about a short
sale. That’s when the lender allows the borrower to sell the house for less than
what is owed. Often, the borrower can negotiate to have the remaining balance on
the mortgage forgiven.

Some states have made it easier for folks to go through the short-sale
process. For example, a new law in California says that if lenders agree to a
short sale — whether they hold a first or second lien — they have to forgive all
outstanding loan balances.

The tax rule has become particularly important as more homes are sold through
short sales, which accounted for 12 percent of all housing sales in the second
quarter, up from 10 percent for the same period last year, according to

However, here’s the problem if you wait too long to start the process: Short
sales are being dragged out for months. Talk to real estate professionals and
many might suggest the term short sale be changed to “long sale.” I’ve seen
several people who wanted to buy a home through a short sale walk away because
the transaction was moving too slowly.

Pre-foreclosures sold in the second quarter took an average of 245 days to
sell after receiving the initial foreclosure notice, according to

In a survey released earlier this year, 71.9 percent of real estate agents
interviewed reported that a short sale could take four to nine months to
complete, according to Equi-Trax Asset Solutions, a company that provides
property valuations. Almost 10 percent of short-sale transactions require more
than 10 months to complete.

When agents are asked to select ways to make short sales easier, 57.6 percent
think lenders should move faster to close the transactions.

A short-sale survey conducted by the California Association of Realtors found
similar results. More than three-fourths (77 percent) of California real estate
agents reported closing short-sale transactions as “difficult” or “extremely
difficult,” the group said.

You shouldn’t rush into a short sale or let your home go to foreclosure just
to avoid a tax debt. But the impending end of the favorable tax rule on forgiven
mortgage debt should be one of the things to consider if you conclude you can’t
afford to keep your house.