Troubled homeowners who get a break from their mortgage lenders could
face a hefty tax bill next year if a key provision expires at the end
of the year, though state laws could determine which borrowers will have
to write a check to Uncle Sam.
Homeowners who live in states where mortgages are non-recourse—that
is, where they aren’t personally liable for the unpaid balance—may avoid
the potential tax hit even if Congress doesn’t act, according to a letter sent by the Internal Revenue Service released by Sen. Barbara Boxer (D., Calif.) on Friday.
The tax provision currently allows some homeowners—mostly those
facing foreclosure—to avoid paying taxes on certain relief that they
receive on their mortgages. The IRS considers debt forgiveness to be a
form of taxable income. That means homeowners who sell their homes for
less than the amount they owe in a short sale could face a tax bill.
In 2007, as the foreclosure crisis spread, Congress exempted some
homeowners from counting certain kinds of forgiven mortgage debt as
taxable income in order to encourage banks and borrowers to seek
foreclosure alternatives. Congress retroactively extended the provision
earlier this year, after it expired on Dec. 31, 2012. The provision is
set to expire this coming Dec. 31 and there appears to be less urgency
in Congress right now to pass an extension.
In the letter to Sen. Boxer, the IRS clarified that certain
non-recourse debt forgiven by lenders wouldn’t typically be considered
taxable income by the IRS. This means that for most California
borrowers, the expiration of the tax provision may not have a meaningful
effect.
“California homeowners have struggled through years of economic
hardships during the Great Recession,” said Ms. Boxer in a statement
Friday. “I am relieved that these families will not face a burdensome
tax penalty just as they are trying to rebuild their lives with a short
sale.”
In the letter, the IRS wrote that “if a property owner cannot be held
personally liable for the difference between the loan balance and the
sales price, we would consider the obligation a non-recourse
obligation.” As a result, the owner would not have to count that
forgiven debt as income.
Other states with laws that prevent lenders from seeking so-called
“deficiency judgments” to recoup defaulted debts from borrowers would
likely be in the same camp as California, the letter said.
Short sales have fallen sharply as a share of overall sales over the
past year as the housing market has rebounded and fewer homeowners have
found themselves underwater. In California, short sales accounted for
around 12.6% of homes that were resold last month, down from 26.7% one
year earlier, according to research firm DataQuickMDA.T +0.82%.
Nationally, lenders have approved more than 200,000 short sales this
year through August, according to Hope Now, an industry coalition to
promote foreclosure alternatives.
