There are two parts to answering this question: the federal taxes and state taxes.
Let’s start with the federal taxes since they are by far the largest exposure you will have.
Federal Taxes on Debt Forgiveness
Federal taxes on mortgage debt forgiveness are covered under the 2007 Mortgage Relief Act. This Act was set to expire December 31, 2012 but it was extended January 1, 2013 and will not expire until December 31, 2013. Learn more how about How The Mortgage Forgiveness Debt Relief Act Affects Short Sales.
The exact title of this act is, The Mortgage Forgiveness Debt Relief Act and Debt Cancellation, which was enacted into law on December 20, 2007. This came at a crucial time in the financial crisis when foreclosures started to spike and homeowners were concerned of the tax implications if their bank forgave the debt.
This law allows homeowners whose mortgage balance is forgiven to claim special tax relief by filling out Form 982 (a new tax form) and attaching it to their federal tax returns. The basic criteria of the law is that the home needs to be a primary residence and the debt cannot exceed $2 million for a joint return and $1 million for an individual return. For even more detail, simply go to the IRS page about the The Mortgage Forgiveness Debt Relief Act and Debt Cancellation.
Prior to this law, debt forgiveness through a short sale or a foreclosure would have resulted in taxable income. As an example, if your home sold for $200,000 and the mortgage was for $300,000 and the bank agreed to forgive the difference, the $100,000 would be viewed as money that you earned and you would be taxed accordingly. You can imagine this would make an already challenging situation even worse. Thankfully, this law has allowed for billions of dollars in tax savings for struggling homeowners over the past four years.
In October of 2008, after only 10 months of this law being passed, Congress quickly realized the benefits and voted to extend it until the end of 2012. If it hadn’t been extended again yesterday, any forgiven amount of debt would be considered taxable income, which would be devastating for homeowners who are already experiencing financial hardship.
Short Sales on Investment Properties
Even though this Act protects only primary residence homes, rest assured we have performed countless short sales on investment properties, too. Do not be misled into thinking that if you are not covered by the Mortgage Relief Act that you will absolutely have to pay taxes. Many of our investor clients have paid nothing, some have had to pay thousands of dollars, and some have received a rebate. Because tax laws are interpreted so differently due to an individual’s income, assets, deductions, and losses on the home, it is impossible to know exactly what the tax impact is on an investment property. Always consult with a very knowledgeable accountant who specializes in real estate to help provide clarification.
State Tax Consequences of a Short Sale
The second part of this frequently asked question is around the state taxes associated with a short sale. If your home is located in New Hampshire where there is no state income tax, there would be no income tax associated with any debt forgiven. Massachusetts does apply a state income tax on the debt forgiven so you may owe taxes. We wish it was as simple as taking the 5.3% state income tax rate and applying it to the debt forgiven but just like all tax laws, they are very interpretive. Many clients are able to avoid the state tax implication by filing insolvency or using the loss of the home to offset the tax burden.
Talk to your accountant on different tax strategies to reduce or eliminate the possibility of taxes owed. Assuming that the bank forgives the debt and does not pursue you for the difference, in a foreclosure you will still be taxed but for much more since the price will be lower.Do You Qualify?