For space limitations, I reduced the wording to the highlights, but I strongly urge you to read this full article by visiting http://www.hwahomewarranty.com/professionals/news/217077-you-need-to-know-the-details-of-the-mortgage-forgiveness-debt-relief-act
Nov 4, 2008 by Chris Kaucnik, Director of Marketing for Home Warranty of America and Michael J. Greenen, CPA, CFP
Brief Background
Prior to December of 2007 if a homeowner lost his house due to a bank foreclosure, and the bank forgave any difference between the price it was sold for and what was owed, the homeowner would owe additional income tax on that portion. Yes, it's hard to believe, but true.
Now, because of the unique stresses in the housing industry lately and on our whole economy, last December Congress stepped in to provide temporary relief in the form of forgiving this debt, but only for the 2007, 2008 and 2009 tax years. After that, the old rule applies again.
To be eligible for this tax relief, the mortgage must be for your principal residence. It does NOT apply to vacation, investment or other properties. And no more than $2,000,000 of forgiven debt can be excluded from taxable income. Well, most of us would fall below that threshold anyway.
Another very important detail in this temporary tax break is if part of the forgiven debt was a home equity loan and used for purposes other than to build, buy or substantially improve the property, that portion is STILL taxable. In other words, home equity loans used for vacations aren't included.
Now, what happens in a short sale? In brief, this can occur when a borrower is behind on the mortgage payments and the lender agrees he can sell his house for less than what is owed on the mortgage. But all proceeds must be turned over to the bank. The portion of the mortgage the bank forgives, PLUS any commission expenses or other selling costs ARE taxable income if this debt is canceled. Yes, even the commission and selling expenses count. No free rides. But, again for taxable years 2007, 2008 and 2009 Congress has provided the same temporary relief in this short sale situation.
Other Scenarios
There are situations where the bank sees a homeowner with a great credit history, but who is having trouble making mortgage payments for a legitimate reason. If the bank agrees to reduce the mortgage by say 25%, this is again considered a cancellation of debt and would have been subject to income tax. But for the above stated tax periods, this new, temporary tax provision forgives this income.
Why is there always a catch! If the homeowner does take advantage of debt cancellation by the lender, they are required, when they do eventually sell, to reduce the basis (original price of the home) equal to the amount forgiven.
What does that mean? A homeowner can now receive a $250,000 (single) and $500,000 (married) capital gain exclusion on the sale of their primary residence.
It is important to also note that this act extended mortgage insurance as an itemized deduction all the way through 2010. Yes, there's a restriction. The mortgage contract has to be entered into between December 31, 2006 and January 1, 2011.
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