Five Questions: Will I Owe Taxes on Forgiven Mortgage Debt?

The Wall Street Journal - by Nick Timiraos

A key tax provision set to expire at the end of the year could trip up the Obama administration’s push to have banks forgive mortgage debt more often for borrowers who are underwater.

Five years ago, Congress passed a law, the Mortgage Forgiveness Debt Relief Act, that would prevent households from having to treating certain types of forgiven mortgage debt as taxable income.

If the provision expires as scheduled on Dec. 31, it could throw a wrench not only into efforts to trim loan balances for underwater borrowers, but also for short sales, where banks allow homeowners to sell their properties at a loss. Real-estate agents from Nevada to Florida have been using the looming expiration as a marketing tool, telling homeowners that now’s the time to do a short sale because come next January, they might owe taxes on it.

The deadline on the debt-relief measure comes as banks are beginning to cut homeowners’ mortgage balances more aggressively as part of the $25 billion settlement reached earlier this year, as a report released Wednesday showed. Federal agencies, meanwhile, are taking steps to make short sales more attractive.

Here are a few commonly asked questions:

How does the relief provision work? Without the measure, a homeowner who owes $300,000 on his mortgage and sells his house for $250,000 would owe taxes on the $50,000 balance that’s forgiven, because it would be considered income by the Internal Revenue Service. This could take away some of the incentive for homeowners to seek a short sale.

Will the relief provision get extended? Earlier this month, the Senate Finance Committee passed a one-year extension, as part of a broader tax package, on a 19-5 vote. Capitol Hill observers expect Congress to ultimately pass an extension of the provision as part of a series of broader tax measures that will come before lawmakers before the end of the year.

“I’m encouraged that there seems to be bipartisan concern about this issue and about not letting this provision expire,” Housing Secretary Shaun Donovan said on Wednesday in a call with reporters. “We are actively looking for opportunities to extend the provision and would hope that we could do that well before the end of the calendar year.”

Is all forgiven mortgage debt covered by the relief provision? No. Many people assume that the provision covers any mortgage debt that’s forgiven, but the measure applies only to homeowners who borrowed money to “acquire, construct, or substantially improve a principal residence,” according to a brief from law firm K&L Gates.

That means debt that’s forgiven on a second home or on a home equity line of credit that wasn’t used to finance home improvements is supposed to be reported to the IRS as income.

Forgiven debt isn’t taxable in some other cases, including where the taxpayer is insolvent or if the debt is discharged through bankruptcy.

What about debt that’s wiped away through a foreclosure—is that covered by the tax provision? It depends. If the mortgage has recourse to the borrower, any cancelled debt is considered income and could be covered by the provision. Debt that’s forgiven through a foreclosure on a non-recourse mortgage isn’t considered income, according to the IRS, so the provision isn’t relevant.

(Non-recourse mortgages don’t allow the lender to pursue the borrower for any deficiency after a foreclosure, while recourse mortgages do. Whether a mortgage has recourse often depends on the type of loan and the state. In California, mortgages taken out to purchase a home are generally non-recourse, while Florida is a recourse state.)

How much would extending the provision cost the government? Extending the provision for two years, as President Obama proposed earlier this year in his budget proposal, would cost $2.7 billion, according to the Congressional Budget Office.