In 2007, former President George W. Bush signed the Mortgage Forgiveness Debt Relief Act into law. The act allows for homeowners who would have otherwise been subject to taxes on forgiven mortgage debt following a foreclosure to avoid having to pay them. This is welcome news for homeowners facing financial difficulties, as the last thing a seller wants to deal with after undergoing a hardship is taxes. Generally, tax payers will be off the hook for taxable income associated with mortgage restructuring and forgiven mortgage debt. However, certain cancelled debt income may be taxable if it does not fall under the exceptions of the Debt Relief Act of 2007.
In the event that a commercial lender cancels or forgives the debt of an unpaid loan, the borrower may have to include the amount forgiven as income for tax purposes. Lenders are required to report the amount of cancelled debt to the Federal Government on a 1099-C, Cancelation of Debt Form. When the money was originally borrowed it was not required to be included as income because of the borrower’s obligation to repay the lender, when the obligation is forgiven, the money becomes taxable because it is now essentially free income.
A simple way of looking at this is if a borrower takes on a loan of $12,000 and then subsequently defaults on the loan after only paying back $4,000, the lender is unable to collect what’s left in the debt and cancels the remaining debt of $8,000. This money is taxable income.
Non-Taxable Debt Income
There are four prominent exceptions to canceled debt income being taxable:
- Bankruptcy: Money owed that is dismissed through a bankruptcy filing is not taxable income
- Insolvency: If a borrower is unable to pay the balance of a debt because the amount of total debt is greater than the fair market value of all personal assets the cancelled debt is non-taxable
- Specific Farm Debts: If the debt is a direct result of the operation of a farm, and greater than 50 percent of the borrowers income from the previous 36 months came from farming, the canceled debt is not taxable
- Non-Recourse Loans: Loans that are non-recourse only allow the lender in the event of a default to repossess the financed property. Meaning a lender cannot pursue the borrower personally in a default. Cancelled debt associated with non-recourse loans is not taxable.
Taxable Income on a Short Sale
One of the most commonly asked questions we hear is “will I have to pay income taxes on a short sale?” The answer to this question is largely dependent on the mortgage type. Although there is no singular answer, you may not have to pay income taxes on the cancelled debt associated with short sale.
Because all government backed mortgages are non-recourse loans, FHA, VA and USDA loan borrowers should be exempt from paying income taxes on cancelled debt. However, if you receive a 1099-C from your lender please contact a licensed tax professional to see if you are eligible for an exemption under the Mortgage Forgiveness Debt Relief Act.
For borrowers of traditional loans, a possibility does exist of income taxes on cancelled debt after a short sale. If the deficiency is forgiven a CPA can help minimize the borrower’s tax-liability. Under the Mortgage Forgiveness Debt Relief Act of 2007, cancelled debt on a short sale should not be taxable if the forgiven debt was used to buy, build or improve a primary residence or to refinance a debt for those purposes.
For short sale related questions contact VA Home Loan Centers at 888-573-4496 to speak with a representative. Remember, VA HLC provides our services free of out of pocket cost to veterans needing to short sale their home.
If you choose to have VA Home Loan Centers represent you in selling your home as a short sale, you can stop using our services at any time. VA Home Loan Centers charges no up-front fees to assist you with your short sale. Our partner real estate brokerages will charge a real estate commission but if the bank agrees to a short sale, this is paid for by your lender. VA Home Loan Centers is not associated with the government, and our service is not approved by the government or your lender. Even if you accept this offer and use our service, your lender may not agree to change the terms of your mortgage including approving your short sale. It is recommended that you continue to make payments on your mortgage throughout the process. Should you default on your payments, you can see a negative impact to your credit report and your home could be foreclosed upon.