As discussed in our earlier post, a major tax break will end on December 31, 2012, that helps Florida home owners facing foreclosures, negotiating loan modifications, or working on a short sale of their home.  For several years, a federal law has exempted the amount that isn’t covered by the foreclosure or short sale or mortgage modification from being considered income for federal income tax purposes. That law has not been extended and its protection ends at the end of this year.

Here are five things that you should know about the income tax benefit for short sales, foreclosures, and loan modifications that ends in December 2012:

1.  What is this federal law and why does it automatically end?

The federal law is a statute called the Mortgage Forgiveness Debt Relief Act of 2007. It is a law passed by Congress that lets you exclude the income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence.

The Act doesn’t say this isn’t income to you; instead, it makes this income nontaxable.

It became effective on December 20, 2007, and it was extended once, in 2008, as part of the  Emergency Economic Stabilization Act.  Federal laws do not live indefinitely; they have a life span and in this law, the end date for the law was included in its language.  It was passed to only be active for a certain amount of time — unless another federal law was passed by Congress that extended its effective date.  That’s happened once.  No new law now means that the tax break ends by the terms of the law as it was passed and extended.

2. The Tax Break Helps People Who Have Had Debt Cancelled: What is Taxable Income Cancelled Debt?

Cancelled debt is debt that has been forgiven.  When you borrow money from a bank for a home loan and then, either in a short sale, loan modification or foreclosure, the bank forgives part of the original mortgage amount, you have cancelled debt.  Since you have received money and are not paying it back, it’s considered to income to you under the federal tax code.  Income that’s taxable.  Except, when it’s not.

Some types of cancelled debt that is not taxable include:

Debt cancelled that is connected to a principal residence debt in accordance with the Mortgage Debt Relief Act of 2007.

Debt cancelled under the federal bankruptcy laws.

Debt cancelled for someone who is legally insolvent.  This is important to many Florida home owners as they consider short sales, foreclosures, and loan modifications after 2012.   If  your total debts are more than the fair market value of your total assets, then you are “insolvent” and some of your cancelled debt may not be taxable income.

3.  There are limits to the Tax Break Applying to You Before It Ends: the Mortgage Forgiveness Debt Relief Act Doesn’t Apply to All House Related Cancelled Debts

The Tax Break, as favorable as it is for Florida home owners and other homeowners across the country, does not cover everything related to mortgages on homes.  It has its limits.

• The Tax Break can only be used for cancelled debt on loans made to buy, build or substantially improve your principal residence.
• It applies only to cancelled debt that is secured by the home.
• The tax break has maximum amounts that are excluded from taxable income calculations: $2 million forgiven ($1 million if married filing separately).

4.  Sometimes refinancing is covered by the Mortgage Forgiveness Debt Relief Act.

Cancelled debt on a refinanced home mortgage will be covered by the Tax Break, up to the amount of the balance of the mortgage at the time that it was paid off by the refinancing.

5.  The Tax Break Covers Forgiven Debt but There’s No Tax Break for Losses

Not everyone gets forgiven debt in a foreclosure; sometimes, people lose money on a foreclosure of their home.  In these instances, that loss isn’t given any special consideration under federal law.  No tax break for these folk.

Larry’s Tip:

When you sell your home in Florida and the bank forgives the balance on your mortgage, this is good news for you because the lender is giving up his state law right to sue you in a deficiency lawsuit and thereafter to execute on your assets via a deficiency judgment.

It’s a victory for you to get this forgiven debt negotiated.

However, there’s still the federal income tax laws to consider. The amount that the bank has forgiven will be considered income to you, no matter how unfair that may feel and no matter how horrific your circumstances may be.

The Tax Break can be a true lifesaver for people in dire need of a fresh start.  However, it’s going to end on December 31, 2012.  Next year, as harsh as it may be, the victory in getting a deficiency amount taken off the bank’s records may still mean a battle for the homeowner.

That hard pressed homeowner might be able to avoid paying tax on that forgiven amount if they can demonstrate that they were insolvent immediately before the discharge, for example, or if they were involved in a bankruptcy.

It will be easier for Florida homeowners to take advantage of the Tax Break before 2012 – but for some, there is still hope that the forgiven debt may not be taxed as income in some situations.

If you have questions or comments, please feel free to Chat with Larry in the comments below, at info@hallandalelaw.com or (954) 458-8655.