Mortgage Debt Relief Act of 2007 Forgiveness of Income Tax Due on Cancelled Debt Set to Expire December 31st 2012

Homeowners are running out of time to take advantage of income tax relief in a short sale or foreclosure of their primary residence.

When the real estate market crashed and foreclosures and short sales began to dominate the lives of millions of homeowners, it was a shock to many to learn that cancelled debt resulting from a short sale or foreclosure would be considered income and would be taxed at their marginal rate.  This “phantom income” known as Debt Forgiveness, Cancellation of Debt or COD, potentially exposed those who were losing their homes to enormous tax bills.

For a taxpayer in the 35% marginal tax bracket, $100,000 of canceled debt (considered a moderate loss in Californiaand very common over the past four years) could have triggered an additional $44,300 owed in income tax – $35,000 to the IRS and $9,300 to the California Franchise Tax Board.

Recognizing the impact this effect would have on homeowners, the Bush Administration passed the Mortgage Debt Relief Act of 2007.  This act created relief for consumers exposed to income tax resulting from cancelled debt in a mortgage workout, short sale or foreclosure on their primary residence if it occurred between 2007 and 2012. The state of California followed suit and also passed legislation that aligned with the federal program.

Now both of these laws are scheduled to sunset (expire) or December 31st 2012.

It currently takes most lenders approximately 3-6 months to actually record a Notice of Default (NOD) the event that triggers the non-judicial deed of trust foreclosure timeline in California. The foreclosure process itself is 120 days or about 4 months long to complete. This means in the worst case scenario it could take 10 months, sometimes longer, for a lender to conclude foreclosure actions.

To be certain that a homeowner will qualify for the current protections against income tax on forgiven debt before the laws expire on December 31st 2012, they need to plan on completing the process in November 2012. This means starting in January 2012.

We cannot predict the political environment around the presidential elections and whether or not these protections will be extended.  If planned appropriately, a short sale can be completed before the end of the year.  If the Lender cannot or will not agree to the short sale, there may then be time enough to complete the foreclosure process prior to the existing protection expiring.

 If you have been considering taking action to resolve your mortgage situation I strongly recommend talking to a qualified real estate advisor and plan to take action no later than January 2012.