By Amy Feldman
NEW YORK, April 2 About 11 million U.S.
homeowners owe more than their homes are worth, according to
real estate data firm CoreLogic, and while taxes may not be the
first thing they think about in deciding what to do, all the
various options have tax consequences.
Until the end of this year, at least, there is a tax break
for homeowners who negotiate debt reduction with their lenders.
Some of these "underwater" owners may qualify for principal
reduction through the massive mortgage foreclosure settlement
announced in February. Others may pursue short sales, in which
the home is sold for less than the bank is owed, or wind up in
But those whose lenders cancel their debt would ordinarily
face the tax man, because cancellation of debt, including
mortgage reduction, is generally taxable. That means if you get
your mortgage reduced by $100,000 and you're in the 28 percent
tax bracket, you'd owe $28,000 in federal taxes on the "income"
you received when your debt was forgiven.
Typically, the only way to avoid those taxes is to declare
bankruptcy or to claim insolvency, which does not require a
bankruptcy filing but still requires that your debts outweigh
your assets. Being foreclosed in a state like California, which
has "non-recourse" rules that prohibit lenders from coming after
you for extra cash after they've taken your house, also exempts
one from taxes.
A special federal tax break to help ailing homeowners, put
in place in 2007, allows them to exclude up to $2 million in
forgiven mortgage debt from their income. To qualify, that debt
has to be for your primary home - sorry, no vacation homes or
With the tax break slated to expire in nine months, if
you're currently sinking under the weight of your home, there's
a reason to move quickly. No one can accurately foresee whether
the provision will be renewed by Congress, and dealing with
underwater real estate takes time.
"These problems are now winding their way through the final
stages, and that's where the tax part comes up," says Larry
McKoy, a certified public accountant and partner at Dixon Hughes
Goodman, in Glen Allen, Virginia.
Even for this year, while that special tax break is in
effect, there are complications. Most important, only the funds
that you spent buying or improving your home count. So if you
took extra cash out of your house during a refinancing or with a
home-equity loan, spent it on vacations or on your kids' college
educations and then ran into trouble, you're out of luck. If you
put part of the money into your home and spent the rest
elsewhere, you'll need to be able to track those amounts.
Another huge issue: Not all states take their cue from the
feds, so even with the federal tax break in effect, you might
still owe state income taxes on the canceled debt.
Principal reductions are relatively straightforward for tax
purposes. You will receive a 1099-C form, for cancellation of
debt, from your lender in the tax year the deal is done. Thus if
you renegotiated your debt and got your principal reduced in
2011, you should have received this tax form already.
ON THE HOOK
Foreclosures and short sales can get more complex. Although
you may think you've finished the deal, if you live in a
"recourse" state, in which the bank can come after you for the
amount you owe beyond what the asset is worth, you may remain on
the hook for years after the fact. In 41 states and the District
of Columbia, lenders can sue for the balance of the debt long
after the house is gone.
(The website HelocBasics has a list of the non-recourse
In cases like that, whether you gave up your home through a
short sale or lost it to foreclosure, there is no official debt
cancellation until you get an agreement to that effect or until
the statute of limitations runs out, and that can take years.
"People think the short sale will wave a magic wand, and
make the bank go away," says Bill Smith, a managing director in
the national tax office of accounting firm CBIZ MHM. "The banks
aren't necessarily pursuing the collection, but they don't have
any real incentive not to keep it. It could hang over your head
for 20 years."
Say, for example, that your home is worth $500,000, and you
owe the bank $700,000. You put your house on the market and you
get an offer of $500,000. You take that offer to the bank and
But if you live in a recourse state, before you sign the
deal, you'd better negotiate away that $200,000 with the lender.
"There are deals coming together," says McKoy, the
accountant. "The homeowner might say, 'What if I scrape together
$60,000, and you go away?' Then the lender counters. That's
going on every day. You're trying to negotiate it away."
Only after the statute of limitations on collecting a debt
runs out is it actually considered canceled for tax purposes.
Only then - and it could be years after the fact - would you
receive the tax form 1099-C showing the canceled debt, on which
you could well owe taxes.
Whether or not you want to think about taxes while you're
struggling to keep your home, McKoy says, "the tax law has a
game plan for you."