There is a very dark cloud on the horizon that will be devastating to those facing foreclosure or even a short sale or loan modification.  In 2007 Congress passed into law 'The Mortgage Forgiveness Debt Relief Act' which provided forgiveness for the taxes that would normally be owed when a home is foreclosed, short saled, or a loan is modified.  This protections of this law disappear on January 1, 2013 leaving millions of homeowners in a very precarious situation.

From the IRS website -

"If you owe a debt to someone and they cancel or forgive that debt, the canceled amount is usually taxable," as income on your tax return. Following a foreclosure, short sale or loan modification, a lender forgiving a portion of your debt issues a 1099 in the amount of the forgiven debt. "The Mortgage Debt Relief Act of 2007 allows taxpayers to exclude income from the forgiveness of debt on their principal residence."

Understanding The Taxation Of Bad Debts

Historically, the way the tax code deals with bad debts is to allow the creditor to write off the debt and require the debtor to declare the forgiven debt as income.  A major exception to this is bankruptcy.  A debtor can discharge their debts in bankruptcy without any tax consequences in most cases.  In fact, this is one of the major reasons that people file for bankruptcy.  Just consider $50,000 added as income to your tax return and what that would do.  Not only would you owe income taxes on this money but it would likely kick you into a higher tax bracket raising the marginal rate that you pay on the income you earn from your employment as well.

2007 - The Mortgage Forgiveness Debt Relief Act

The Congress assessed the landscape of America's economy and real estate crisis and decided to forgive the tax consequences of those that lost their home to foreclosure. The provision was written to also forgive the tax consequences associated with a short sale or loan modification as well.  So, on the one hand the lenders were allowed to take their write offs but the government would not require the debtor to face any tax consequences.  This applied only to principal residences and was a great move that likely kept millions out of bankruptcy.   The 2007 Act was never meant to be a long term part of the tax code and is set to expire at the end of 2012.   

Why The Consequences Of This Revived Tax Are Immediate

Most short sales and loan modifications take months to finalize.  As a result, even a person that is beginning to work on one of these kinds of transactions today will face the new tax since closing by December 31 is highly unlikely.

Will Congress Act Before The End Of The Year?

It is unlikely that Congress will take any action on this due to the upcoming election. The most that can be realistically hoped for is that the new Congress will enact a retroactive measure early in 2013.  This may or may not happen, and individuals that follow tax legislation closely are split on their expectation of an extension of the 2007 Act.

What To Do Now

If you find yourself in foreclosure, needing to complete a short sale or loan modification, grab a calendar and circle December 31st in red.  Do everything in your power to make the forgiven debt stay within 2012.  As an example, if you are currently facing foreclosure you may want to talk to an attorney about the tax consequences and what your options are.  Believe it or not, many real estate attorneys are not even aware of this change in the tax laws.  Factoring this into what you do may be tricky.  For example, you may want to avoid foreclosure litigation and simply sign your house over to the bank so that your debt falls into 2012 and does not spill into 2013.   This tax law change adds one more element to what are very complicated decisions involved in owning a home that is under water. 

Helping you make the most of God’s money!

James L. Paris
Editor-In-Chief ChristianMoney.com 
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