I recently attended a networking event of local Bay Area realtors, and was shocked to hear a young realtor say she had heard that the short sale homeowners tax exemption, scheduled to expire on December 31, 2012, had been extended. I quickly informed her that her information was incorrect, and that the exemption remains on track to expire at the end of the year. My purpose in this blog is to provide a status update regarding the homeowners exemption, and to clarify the availability of another potential tax exemption for homeowners unable to complete their short sale in time.
As a reminder, homeowners whose mortgage debt is forgiven, reduced or cancelled in a short sale, foreclosure or loan modification will receive a 1099 from their lender in the amount of the unpaid debt. And unless they qualify for a tax exemption, they will have to pay income tax on the 1099 amount. Since 2007, many homeowners have been able to avoid the tax by applying for the IRS Form 982 homeowners exemption. (The exemption does not apply to all home mortgage debt; there are limitations that can be explained by a knowledegable tax professional.)
First, it is correct that President Obama has proposed that Congress extend the homeowners tax exemption, also known as the Mortgage Forgiveness Debt Relief Act, through 2013. But it is only a proposal. The Senate Finance Committee has also approved a bill to extend the Act; however, that’s as far as it’s gotten. And the highly partisan congressional and presidential battles makes it virtually certain that nothing will happen until after the November 6th national election.
The hope is that the “lame duck” congress will then extend the exemption. Knowledgeable prognosticators currently place the odds at 60/40 in favor of the extension; however, that is only speculation. There is a significant risk that the looming “financial cliff” and public pressure to reduce the deficit may torpedo the exemption. Congressional estimates are that a one-year extension of the Act will reduce government revenues by as much as $1.3 billion.
Homeowners facing potential tax liability from mortgage debt cancellation — resulting either from a foreclosure, short sale or loan modification — are urged to determine if they qualify for the “insolvency” exemption. Unlike the homeowners exemption, the insolvency exemption does not expire this year. And it is available for more types of mortgage debt that the homeowners exemption.
Briefly, if the fair market value of all your assets, including your retirement accounts, is less than your total debt, you are “insolvent” for tax purposes. Depending on the extent of your insolvency, you may be able to reduce your 1099 mortgage debt tax liability. For example, if you have $100,000 in 1099 mortgage debt income, and your debts exceed your assets by $50,000, your taxable income is reduced by $50,000. (Again, these calculations should be done by a qualified tax professional.)
Please contact me if you need help determining your individual situation. It is critical you make no decision unless and until you know the consequences. An incorrect choice may potentially place you in even worse condition, something few homeowners can afford.