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  • Robert Weed

Bankruptcy, short sale, debt forgiveness tax and the fiscal cliff

The 2007 Mortgage Forgiveness Tax Relief Act expires December 31, 2012.   That’s one of the tax cuts, put in place when George Bush was president, that are about to expire.  This one may force more people to file bankruptcy.

The Mortgage Forgiveness Tax Relief Act helped people whose houses lost value during the crisis to use short sale and avoid bankruptcy.  If it’s not extended, bankruptcy will be better.  Because of the “fiscal cliff,” it looks likely the Act will expire.

What’s the fiscal cliff?

In August 2011, Congress and the President set December 31 2012 as the deadline for sensible plan to reduce the federal deficit.  If no sensible plan can be worked out–drastic spending cuts and tax increases hit.  Those drastic changes are now called the fiscal cliff.   After 16 months, no sensible plan has yet gained support.  There are three weeks left.

Since one of the goals of the fiscal cliff negotiations is to raise money, extending this tax break might be a hard sell.

How Did the Mortgage  Forgiveness Tax Relief Act help people stay out of bankruptcy?

The reason is taxes.  The general rule is that debt forgiveness is income.   A short sale is income.  And the income tax taxes income.

Look at it this way.  Suppose you borrow $1000 from your boss.  Then the boss says you don’t have to pay him back.  That $1000 loan is changed into a $1000 bonus–and you owe taxes on that.

The same rule applies in a short sale.  Bank of America lends you $400,000.  Then they say you only have to pay back $300,000.  Bank of America has given you a $100,000 “bonus”–you owe taxes on that $100,000.  (About $30,000 in taxes, depending.)  Unlike your boss, who might forgive a loan of $1000, Bank of America is sure to issue you a 1099-C after the short sale.   So the IRS KNOWS $100,000 in debt was forgiven.

(This same problem comes up when people negotiate a settlement with their credit cards.  People who don’t know about debt forgiveness tax are blindsided when they get a bill from the IRS.)

Here’s a 1099-C, telling you and the IRS that debt has been cancelled.  Cancellation of debt is “income.” And the income tax is a tax on income.

The Mortgage Forgiveness Tax Relief Act said you don’t have taxes on money forgiven in a short sale–from 2007 to 2012.  That means a homeowner who got approved for a $300,000 short sale on the $400,000 mortgage could walk away clean.  (The Act only applied to your residence–short sale on investment property was still taxed.)  Starting January, unless the law is extended, there would be about a $30,000 tax on the short sale.  Ouch!

How does bankruptcy come in?

There’s no debt forgiveness tax on debts wiped out in a bankruptcy.  So one way for our homeowner to avoid a tax on that $100,000 is to file bankruptcy.  Then after the bankruptcy, the homeowner can still do the short sale; of just let the bank foreclose.  Either way, no debt forgiveness tax.

Are there other ways to avoid tax on a short sale?

There’s one.  If you are “insolvent”–meaning hopelessly in debt–then the tax is forgiven.  Your accountant can help you with that.  Starting 2013, if you are looking to do a short sale, and you don’t want to do a bankruptcy, you need to talk very carefully with a CPA or other tax adviser  to see if you can afford to pay, or can avoid, the tax on the debt forgiveness income.

You may also want to talk to a bankruptcy lawyer.

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