It may not be the end of the world, but in 2012, when the Mortgage Debt Relief Act (MDRA) of 2007 expires, it will end one of the greatest money savers available to distressed homeowners.
MDRA is a federal tax law that allows qualified taxpayers to exclude from taxation, income derived from the forgiveness or discharge of debt associated with a principle residence.
In a short sale, the difference between the amount owed on the mortgage and the amount of the sale, can be considered income. A short sale occurs when a lender agrees to write off a portion of your mortgage, typically a portion that is higher than the value of your home, provided a capable buyer is available.
For example, if you borrowed $500,000 and sell it as a short sale or lose it in foreclosure and the lender gets $200,000, you gained $300,000 because you borrowed it without having to pay it back. If you are in the 35 percent tax bracket, then you would owe the IRS a whopping $105,000.
Only in the 15 percent or so bracket? You would still owe $45,000.
Likewise, in a mortgage modification or other mortgage restructuring that includes a principal reduction, the amount of the reduction can be considered taxable income.
MDRA has allowed struggling homeowners to unload this tax burden under certain circumstances.
• It applies to up to $2 million ($1 million if married and filing separately) in forgiven debt for calendars years 2007 through 2012, but only if the forgiven debt is related to a decline in the home’s value or the taxpayer’s financial situation.
• The exclusion applies only to the debt on the principal residence. Vacation homes, investment properties and other second homes don’t qualify.
• The tax rule can be applied to debt used to refinance your home, provided the principal balance of the old mortgage, immediately before the refinancing, would have qualified.
See “The Mortgage Forgiveness Debt Relief Act and Debt Cancellation” for additional information.
There are no current planned extensions of this rule. Don’t expect one. Federal legislators allowed the MDRA’s mortgage insurance tax deduction provision to expire at the end of 2011 with little more than a whisper.
If you’ve been considering a short sale or other action that could generate forgiven debt, don’t procrastinate. The law doesn’t expire until Dec. 31 but, when it comes to a short sale, the next 11 months is a very short period. The sale must close by Dec. 31.
Five to 6 months can be the norm, but there are some exceptions to the rule and you never know how long a short sale will take. I closed two short sales in January, 2012. They began in April of 2011. I’ve witnessed short sales taking more than a year to complete.
Buyers can cancel a short sale if they find something better, cheaper or lose their job. The lender can balk. An estimated 40 percent of all short sales are sold and resold two or more times before closing escrow.
Additional short sale relief
State tax laws vary when it comes to taxing forgiven debt. When MDRA expires, remaining provisions that exclude forgiven debt as taxable income on the federal level will be limited to bankruptcy, insolvency, and certain farm property debt.
In California, short sale laws say California lenders who agree to a short sale must accept the agreed upon short sale payment as payment in full for the outstanding balance of all loans, including the first and second mortgages.
The laws only apply to short sales, but not foreclosures and a few restrictions apply.
When it comes right down to it, this is the year and this is the time when you need to do something if you are in are upside down in a home and you are having problems making your payments.
If you owe considerably more for your home than it is worth, it could be 15 years or more before you break even, depending upon how upside down you are. When you are upside down, you have a bad debt and are effectively paying rent until you are right side up.
I’m not recommending that every upside down homeowner sell the farm. You should know your options and do the math, in a timely matter, to see what makes sense to you.
Put those attached-to-your emotions aside, think like a business person (your home is likely your most valuable asset) and make a decision for you and your family based on your needs – not your lender’s needs.
Lenders unload bad debts all the time without thinking twice about it.