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Congress must extend Mortgage Forgiveness Debt Relief Act (column)

By Dawn Cutaia

I'm inspired when Congress makes decisions that show actual thought. Unfortunately, Congress's failure to extend the Mortgage Forgiveness Debt Relief Act, which was in effect from 2007 to 2013, is so blatantly bad for homeowners, neighborhoods and real estate professionals I have to wonder whether the good decisions Congress makes happen just by accident.

In order to understand why the act is important, you need to understand its purpose, and that requires an understanding of real estate, tax and debt law. I know — you can barely contain your excitement, so much so that you might forget that this column is for entertainment purposes only and if you have legal or tax questions you should seek the advice of a lawyer or accountant. We all know no one should ever take legal advice from a newspaper column, especially mine. OK, now that we got that out of the way, take a deep breath, sit back in your seat, and let the fun begin.

Since the real estate market crashed in 2007, many people now owe more on their mortgage than their house is worth. Normally this isn't a big deal; home prices will eventually go up again. But what if you can't wait? What if you have to sell because you can't afford your mortgage due to a job loss, divorce or illness?

When you sell, the mortgage lender won't release its lien unless it's paid in full,. A homeowner needs enough money from the sale to cover the costs and full balance on the mortgage, or bring the balance to the closing. Most people don't have that kind of cash, so they may just walk away from their homes, or file bankruptcy, or try to do a short sale.

What's a short sale?

A short sale is where a homeowner is able to convince the mortgage lender to release its lien even if the note is not paid in full. The benefit to homeowners is that their house is now out of their name, and they don't have to worry about mowing the lawn, paying for water/sewer and HOA fees. It may prevent a bankruptcy if there are no other significant debts.

To justify a short sale a homeowner must convince the lender that he or she cannot afford the mortgage and the house cannot sell for the full balance on the note. A homeowner does not get any money out of the sale; but the lien is released, the house is sold and very often (but not always) the deficiency is forgiven so the homeowner does not have to pay it back. And it is that debt forgiveness that can cause problems for homeowners under the current law.

If a creditor forgives a debt, you could be required to pay income tax on that debt. This is called "debt discharge income tax." When a creditor forgives more than $600 in debt, it's required by the tax code to send you a 1099, because the IRS assumes it is income to you. For example, if you owe me $600 and I forgive the debt, the IRS says that's the same as me giving you $600 (don't spend that $600 all in one place). However, usually debts are forgiven for consumers as part of an "offer in compromise," which is a settlement. People who are in a good financial position are usually not the ones negotiating settlements; it's people who are already suffering financially — and those are the people who are getting stuck with a debt discharge tax debt.

Now, imagine if your mortgage company forgives $20,000 of your mortgage so you can sell your house at a short sale, and the IRS says that's like you made $20,000. That would be a significant burden on most people. Congress realized this burden and in 2007 enacted the Mortgage Debt Forgiveness Act. Pursuant to this law, people who have debt forgiven by their mortgage company for their primary residence do not have to pay income tax on the forgiven debt. Unfortunately, this act expired in 2013 and Congress has failed to extend it.

There are still ways to avoid debt discharge income tax and do a short sale. You can file IRS Form 982, and prove to the IRS that you were insolvent immediately before the debt was forgiven. To do this, your assets must be worth less than your debts, but assets include things like 401(k)s and interests in pensions, something people don't always consider assets because they don't have access to them. If you are going to have debt discharge income and not file bankruptcy, you should talk to your accountant before the end of the tax year.

The only time you never have to pay tax on a forgiven debt is when you file bankruptcy. Debts discharged in bankruptcy are not taxable because the IRS automatically considers you to be insolvent when you file bankruptcy. Of course, timing matters. If a debt is forgiven in 2013, and you file bankruptcy in 2014, there is a question as to whether you were insolvent at the time the debt was forgiven — and if not, did a tax liability arise that is not dischargeable. If a debt was forgiven in 2013 and you file bankruptcy that same year, you should be good.

If Congress extends the Act in 2014, mortgage forgiveness will likely not be taxable. If they don't, people who maybe didn't have to file bankruptcy may have no choice but to do so. The failure to extend this act hurts homeowners who are forced to file bankruptcy, and it also hurts neighborhoods because it reduces the incentive to do a short sale — and foreclosures damage the a neighborhood's home prices more than short sales. And it hurts those in the short sale business, who are making a living helping homeowners sell their underwater properties, many of whom are Realtors who were hit hard by the recent real estate crash.

So while Congress is fighting about all the ridiculous things it likes to fight about, homeowners, real estate professionals and neighborhoods are suffering.

Read the original column by Dawn Cutaia, Esquire here: (note that ydr.com sometimes closes links and this link may stop functioning):

http://www.ydr.com/letters/ci_25393383/dawn-cutaia-congress-must-extend-mortgage-forgiveness-debt