This is actually a very important issue this year because of a change in the tax laws that’s due to occur at the end of the year that will result in a loss of big tax savings on January 1, 2013, and beyond.
Generally, when a person receives a cancellation of his debt, he is treated as having taxable income in the amount of the cancelled debt. For example, if you owe a bank $20,000 on a line of credit you took out for your business, your business subsequently is unable to repay the loan, and the bank agrees to forgive the loan, then you are treated as having $20,000 of taxable income.
The same is generally true for home loans. For example, assume that when you purchased your home, you received a $250,000 mortgage from Local Bank to assist with the purchase. Now assume that it’s 10 years later and as a result of a down economy and a few home equity lines of credit you took out on your home, you currently owe Local Bank $260,000, while your home is only worth $220,000. If you were to sell your home today, you would still owe Local Bank $40,000. Depending on the loan terms and on the bank, Local Bank could forgive the $40,000 shortfall. However, even if Local Bank decides to forgive the remaining balance of the loan, the IRS would generally require that you treat that $40,000 as taxable income!
Fortunately, when the real estate market began to crash back in 2007, Congress saw the problem on the horizon and decided to do something about it. Congress passed legislation to allow homeowners to exclude from taxable income any mortgage debt written off by their lenders in a loan modification or short sale. This means that as long as the mortgage was on the personal dwelling of the taxpayer, the taxpayer in our example above would not have to include the $40,000 in his taxable income.
Unfortunately, the exclusion provided by Congress will end on December 31, 2012. As a result, any loan modifications or short sales that occur on or after January 1, 2013, will again require the homeowner to recognize any loan forgiveness as taxable income.
In summary, if you are considering trying to pursue a loan modification or short sale for your home, you should make sure to do so by the end of this year. Waiting even just one extra day could result in a huge tax burden.