The Mortgage Forgiveness Debt Relief Act expired on December 31, 2013, at the stroke of midnight. As many Americans celebrated the arrival of the New Year, this celebration will not last too long for the underwater homeowner.
The Mortgage Forgiveness Debt Relief Act came about in 2007 when our government responded to the outcry of its citizens. The goal of the law was to prevent the underwater homeowner from being taxed on the deficiency, which resulted from the short sale, foreclosure or deed in lieu of their homestead property. In other words, the government did not want the homeowner to be saddled with debt after the loss of their home.
How Did This Work?
Let’s say that Jim’s house was underwater by $75,000. Jim decides to do a short sale. He hires a realtor, secures a buyer for a fair price and submits the contract to his lender. He sends voluminous documents to his lender month after month, only to be told that he needs to send more documents. (Sound familiar?)
At the end of the day, the lender starts a foreclosure against Jim. Jim is told that the lender will not proceed to sale- yada, yada, yada… Jim gets concerned anyhow. Well, despite what the lender told Jim, the foreclosure goes through and a judgment is entered against Jim. After the foreclosure sale, Jim is left with a debt of $75,000. Now the bank has two (2) options. Option 1; the bank can pursue Jim for the $75,000. This may cause Jim to file for bankruptcy protection (something he should now think about immediately). Option 2; the bank can waive the deficiency. If it thinks it cannot collect from Jim and tells the government it is taking the loss on this debt (writing it off), but the government can say (IRS Code) that the lender must issue the 1099C for the cancellation of the debt, Jim could be taxed on the difference. OUCH!
Well, before 2014 Jim could go see his tax advisor and exclude this 1099C from his taxable income because of the Mortgage Forgiveness Debt Relief Act. As of today, this option is no longer available to Jim or other underwater homeowners in the United States.
Why Would Congress Let This Expire?
Great Question! My only answer is this: Our current politicians are more concerned with their re-election rather than doing the right thing. We have a Democratic Senator in Florida named Bill Nelson. In the past, Senator Nelson pushed for extensions of the Mortgage Forgiveness Debt Relief Act, and through his efforts, the law was extended twice. When asked why there won’t be another extension of the law, he stated that there wasn’t enough support from other states. So, I guess you just give up and tell people who tried and tried to save their underwater homes that we are sorry- you should not have tried so hard and walked away sooner. Since you tried too hard, you are going to be taxed on the difference.
What Does This Mean to the IRS?
The IRS will now consider any cancellation of debt to be income to the homeowner. Accordingly, in our example above Jim will have $75,000 added to his taxable income. Jim went through a foreclosure, but the same holds true for debt from a short sale or a deed-in-lieu.
Are There Any Exceptions To This Disaster?
Yes, there are two (2) exceptions. The available exceptions depend upon persons’ assets, and they need to be explored with competent counsel.
- Bankruptcy: Anyone who has an underwater home should definitely consider filing for bankruptcy protection, especially if they have other assets. I would highly recommend anyone in Jim’s position to schedule a consultation with an experienced bankruptcy attorney as soon as possible to discuss his or her options.
- Insolvency: The second exception requires an individual to look at their assets and debts. If their debts exceed their assets, they are legally insolvent and may claim the exception to the tax hit.
Assets are treated differently in Option #1 and Option #2 so it is best to speak with a bankruptcy attorney first and then your tax advisor if necessary.
Bankruptcy May Be a Better Financial Strategy for You!
I know this sounds crazy, and you have never thought about bankruptcy, but I don’t make the game or the rules. My job is to craft a financial strategy for my clients, which help them achieve their financial goals. If using bankruptcy as a financial planning tool makes good financial sense, then, by all means, use it. If filing for bankruptcy is your second best option, then do not file bankruptcy.
It’s your decision. I just wanted you to know that you have options. By the way, if you think your elected officials aren’t working hard enough for you, you can always use your vote next election. I certainly will.
