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IRS
Kicks Homeowners While They Are
Down
by Kenneth R. Harney
Saturday,
May
5, 2007
For homeowners who are seriously
delinquent on their mortgages and hoping for relief, the
Internal Revenue Service has bad news: If your lender
agrees to modify your loan and forgive any of your debt,
you could owe federal income tax on the amount
forgiven.
Think of
it as the tax code's "kick 'em while they're down" rule.
When personal debts are canceled by a creditor, the
amount forgiven is treated as ordinary income under the
Internal Revenue Code, except in some situations such as
insolvency. Worse yet, the lender is required by law to
report the canceled amount to the
IRS.
Ouch! This
is especially bad news for the growing numbers of
credit-impaired subprime borrowers who find themselves
"upside down" in the current real estate market: They
owe more on their mortgage than the value of their
house, thanks to noxious combinations of zero down
payments, declining property values and hefty payment
increases they can't
afford.
Diane Thompson, a lawyer with theLand of
Lincoln Legal Assistance
Foundation in East St. Louis,
Ill., tells
of one client who learned about the tax code's Catch-22
the hard way. After the homeowner negotiated a loan
modification agreement with her lender, she assumed that
she was done with the matter. But a year later, the IRS
came after her, demanding a large tax payment on the
amount the lender forgave -- a tax bill that was equal
to her annual income. As required, her lender had
dutifully submitted a Form 1099-C to the IRS, alerting
the agency to the woman's extra "income" from the loan
modification.
The
homeowner never received that income in any tangible
way; she couldn't deposit it in her bank account. But
under federal law, the IRS had every right to come after
her for unpaid taxes.
Similar
situations are likely to pop up around the country in
the coming year as lenders bend over backward to modify
thousands of troubled loans to prevent foreclosure.
Proposed legislation on Capitol Hill could soften some
of the impact on financially stressed homeowners,
however. The Mortgage Cancellation Tax Relief Act of
2007 (H.R. 1876) would amend the tax code to exclude
debt forgiveness on principal home mortgages from
treatment as income.
Introduced
in mid-April by Reps. Robert E. Andrews (D-N.J.) and Ron
Lewis (R-Ky.), the bill would allow lenders to
restructure delinquent mortgages without worrying about
income-tax hand grenades hitting their borrowers the
next year. The legislation could assist many other
homeowners in financial trouble who negotiate
pre-foreclosure "short sales" or deeds in lieu of
foreclosure, or those whose foreclosure proceeds are
insufficient to pay off their mortgage
debt.
Short
sales are increasingly commonplace. Say you are
seriously behind on your mortgage payments, and a loan
modification or rate reduction won't solve the problem
because you have lost your job. As an alternative to
foreclosure, your lender might suggest a quick sale of
the house, often to an investor who will buy it as-is at
a discounted price. If the short sale proceeds are
$10,000 less than the outstanding mortgage balance and
your lender agrees to forgive that amount, the
Andrews-Lewis bill would allow you to obtain that relief
tax-free.
Under
current law, your lender would be required to report the
$10,000 in phantom income to the IRS. Ditto if you went
to foreclosure and the sale proceeds yielded $10,000 --
or $50,000 -- less than the outstanding debt owed to the
lender.
Proponents
of the debt-relief bill argue that short sales, mortgage
delinquencies and foreclosures are painful situations
for most homeowners and that there's no public policy
purpose served by smacking them with tax penalties that
make things even worse. In the case of below-market
short sales, for example, most homeowners have already
suffered sizable capital losses that are not
tax-deductible. They've lost thousands of dollars in
equity.
Why pile
on?
The
outlook for the bill: It's currently before the
House
Ways and Means Committee,
Congress's primary tax legislation body. Because most of
the majority-Democratic housing and banking committee
leaders have called on banks and mortgage companies to
work out solutions to keep troubled homeowners out of
foreclosure, a bipartisan tax fairness bill like this
one should have a reasonable chance of
passage.
Kenneth R. Harney's e-mail address is KenHarney@earthlink.net. |
