IRS - The "Kick 'Em While They're Down" Rule

By
Mortgage and Lending with Cognicorp Mortgage Banking Advisory

In his weekly syndicated column, Kenneth Harney pulled back the curtain on a nasty piece of IRS tax code that can penalize homeowners with foreclosures and short sales. 

Because the IRS treats canceled debt as ordinary income, homeowners that "work something out" with their lender may inadvertently add tens of thousands of dollars to their annual tax liability.

According to the tax code, when a creditor agrees to cancel a personal debt of $600 or more, it is required to submit a 1099-C, Cancellation of Debt form to the IRS.  And, when the IRS receives this form, it treats the canceled debt as income.

So, if your mortgage lender agrees to "forgive" $40,000 on your mortgage in a short sale, you are required to report that $40,000 as income to the IRS -- even though you never physically held the $40,000.

This is how a person's tax liability can dramatically increase.  Imagine if you were taxed on $40,000 that you never "earned".

Capitol Hill is taking steps to offer relief to homeowners by modifying the tax code related to cancellation of debt. 

The Mortgage Cancellation Tax Relief Act of 2007 would amend the tax code to forgive debt cancellations on primary residences and is currently before the House Ways and Means Committee, the primary tax legislation body of Congress.

 

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Rainmaker
223,559
Laurie Mindnich
Centennial, CO
Thank you for the reminder- this is a real down side for individuals that are already struggling financially.  While I see the upside (you get the financial advantage, less taxes) typically, people in this situation are hard pressed to make mininum payments, much less a chunk to the IRS, and the IRS is a much more powerful foe when collecting their money-
May 11, 2007 06:36 AM #14
Anonymous
Anonymous
Ouch!  That hurts, doesn't it.  I do know that lenders have ways of getting around this so it pays to cooperate with a lender if the homeowner finds oneself in that position. 
May 11, 2007 06:37 AM #15
Anonymous
Julie
Sorry, but I'm with Don on this one. As a homeowner who bought a house I could afford and responsibly pays all my bills, even in a tight month, I totally agree with this law (which also applies to credit card debt and other debts that are lowered and written off). I'd love for someone to swoop in and chop $50K off my mortgage with no cost to me.Why should I be penalized because I *can* pay my mortgage payment each month? 
May 11, 2007 07:53 AM #16
Ambassador
1,892,377
Jeff Dowler CRS
Solutions Real Estate - Carlsbad, CA
Carlsbad CA Homes for Sale (760) 840-1360

Thanks for sharing this information, Tony. I am aware of this but many sellers are not. It's something I make sure I let people know could be an issue and to consult their tax adviser. It's a tough situation - some people get into trouble and can't help their circumstances (e.g., family illness, losing) and this adds insult to injury. But then there are those who simply are irresponsible, overspend, and so on. So who deserves some sort of break (but perhaps not walk away free and clear) and who does not? Not sure what the solution is.

Jeff

May 11, 2007 09:08 AM #17
Rainer
3,575
Robert Kerr
Kerr Financial - Warwick, RI

A loan that you don't pay back is income. That's also true for credit card debt.

I don't see what's so complicated about that.

May 11, 2007 09:11 AM #18
Rainer
48,815
Lania DeMers
Rocky Mountain Realty Co. - Colorado Springs, CO
Broker, Rocky Mountain Realty Co.
Not hard to understand. A loan that YOU don't pay back is income, (that is assignable and assiginged to another entity...the lender in the case of a mortgage debt), The lender is entitled to get paid back, but not from two or more parties AND also to have the advantage of claiming tax and insurance loss on top of that. If you rent a property to a person on a lease and they don't pay, you can't collect rent from a new tenant and claim a loss as though the property were still vacant and you were going broke because if it. That's getting paid TWICE for the same property.
May 11, 2007 09:33 AM #19
Anonymous
Anonymous
So, if someone files bankruptcy and the debt is cleared, they're back into debt to pay the tax liability for the forgiveness of debt?
May 11, 2007 09:40 AM #20
Rainer
47,758
Tony Gallegos
Cognicorp Mortgage Banking Advisory - Marietta, GA

Sounds like we all agree to disagree. It does seem most individuals on this post do have empathy for the homeowners though?

Mark - My friend from Soundbite...thanks for the kind words!

May 11, 2007 11:05 AM #21
Rainer
3,575
Robert Kerr
Kerr Financial - Warwick, RI

Sounds like we all agree to disagree. It does seem most individuals on this post do have empathy for the homeowners though?

It's hard for me to feel empathy for people who were careless with their mortgages, HELOCs or credit cards. And it's especially hard for me to sit back while politicians talk about using my tax money to help bail them out. Those of us who were responsible with our credit get the double whammy while those who were reckless get a bailout?

Is that fair?

May 11, 2007 11:25 AM #22
Rainmaker
132,791
Ana Connell
G & C Properties - Burbank, CA
Burbank Real Estate Agent
Good post.  This law has been around for some time, but most folks are not aware of its existence because they've never(happily) had to deal with this scenario.  I would advise all clients in that situation to consult with a tax law attorney/CPA.  I know of situations where the amount has been whittled down to almost nothing using home improvement deductions etc.
May 11, 2007 11:46 AM #23
Rainer
47,172
Jeff Fulgham
T.U.P. Realty - Tupelo, MS
Broker E-Pro ABR
I have a question. If you are forgiven for 40000 dollars on a home. Is that not income. That is 40000 you don't have to pay. The mortgage company is having to pony up for you.
May 11, 2007 12:05 PM #24
Rainer
47,758
Tony Gallegos
Cognicorp Mortgage Banking Advisory - Marietta, GA

Like most issues in life, I don't think the answer is a simple yes or no. There are circumstances in which a person lost their job (like what's happening in the rust belt) and can not get another. Let's say this person was not irresponsible with their finances, yet with the loss of emplyment in a geographic region the real estate values dropp and the home purchased also drops in value. Because of the loss of home value, they can not sell the property for what they owe, however they are able to negotiate a short sale. If this person does not make any money off the short sale and realizes no financial gain, no I don't think it is income, nor should it be treated as such by the IRS.

If individuals exhibited financial irresponsibility and gained financially, it should be treated as such. However, who decides what the litmus test for irresponsibility is?

The anwer is not balck and white.

May 11, 2007 12:57 PM #25
Rainmaker
35,436
Carla Starkie
360 Mortgage, Inc. - Colorado Springs, CO
Full service residential mortgage broker
I forget who it was, but we have a guy here in Colorado who has (for YEARS now) been talking about how we should have sales tax as our only tax- and just hike up our sales tax rates.  At first I thought he was a quack, but the more I think about it, the more it makes sense.  You get taxed on what you spend instead of what you make.  It would be soooo much simpler- no tax reporting at all except sales taxes.  No loopholes, it would encourage saving, maybe even help control inflation...  I'm sure that parts of it would be more complicated than I'm letting on here, but certainly more simple than where we are now.  And those things that are normally tax deductable- just use your tax ID number to avoid the sales tax.  Yes, that could be abused- but probably no worse than phoney deductions are now.
May 11, 2007 01:03 PM #26
Rainer
47,758
Tony Gallegos
Cognicorp Mortgage Banking Advisory - Marietta, GA

Oh yes, a VAT tax system.

May 11, 2007 01:10 PM #27
Rainmaker
351,634
Michael Eisenberg
eXp Realty - Bellingham, WA
Bellingham Real Estate Broker
The government as usual is taxing those that can least afford it, more than the millionaires and billionaires who benefit so much from our tax laws.
May 11, 2007 02:08 PM #28
Rainmaker
181,655
Sara Bonert
Zillow - Atlanta, GA
Real Estate Internet Marketing

First all, what number are these people calling to get their mortgages forgiven because I would like it....  :) 

I have been reading a lot about this lately.  If you are basically "given" $40,000 of income, I do think tax should be paid on it.  Although if you are in a situation where your debt is being forgiven, you probably don't have a lot of extra money to pay this laying around, but you are also probably in a lower tax bracket.  However, I still think the homeowner should be responsible for the taxes. 

May 11, 2007 03:11 PM #29
Anonymous
Anonymous

It also includes bankruptcy and probably. The IRS is going to want it's share of all forgiven debt. Nice Guys!

 

May 11, 2007 03:25 PM #30
Rainer
122,017
Christy Powers
Keller Williams Coastal Area Partners - Pooler, GA
Pooler, Savannah Real Estate Agent
I did not know this. It's funny cause this is actually very pertinent to a customer right now.
May 11, 2007 06:00 PM #31
Anonymous
Anonymous
Since it could or could not affect the seller, its best to point them in the direction of a tax professional for the clarity and updates.
May 11, 2007 06:20 PM #32
Rainer
15,978
Robert Cramer
Five Star Property Inspections - Belleville, IL
Darn....now i'll have to get a home equity loan to pay my taxes......wait....I don't own the home anymore.  I really hope one of our great Presidents steps up to the plate and reforms the tax code......one needs a law degree to pay their taxes.....sad, very sad.
May 11, 2007 09:51 PM #33
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