Your Mortgage Debt Was Forgiven, But Do You Owe Tax On That?

Some homeowners have been able to negotiate their way out of underwater mortgages and have emerged free and clear, due to short sales, foreclosures and other options that they may have had available for their situation.
Or have they?
If you managed to get out of a bad mortgage, you do need to confirm you don’t run afoul of the IRS by failing to pay any applicable tax on that loan forgiveness.
Cancellation of Debt
When a bank or other lender forgives a debt, some accounting must be considered. A loan does not qualify as income, because you have to repay the lender with interest, so that money “costs” you.
If the loan is forgiven, the amount “cancelled” can be counted as income, as you received money and did not pay it back. This seems particularly unfair in the context of underwater mortgages; given the property is no longer worth the original loan value, but the “gain” is based on the loan value.
The Mortgage Forgiveness Debt Relief Act
Congress recognized that for many people, if you are in a financial circumstance that necessitates a cancellation of debt, receiving a tax bill for the mortgage forgiveness, might not feel appropriate.
The Mortgage Debt Relief Act of 2007 to allows taxpayers to avoid liability for the “income” resulting from the discharge of debt on your principal residence.
To be eligible, the debt forgiveness must have occurred from 2007 through 2012.
The debt must be related to a “decline in the home’s value or the taxpayer’s financial condition.” $2 million may be forgiven ($1 million if married filing separately.)
Equity loan debt qualifies, but only if the proceeds were used for improvements to the home. If you used a $20,000 home equity loan for paying off credit card debt or buying a car, it cannot be excluded from your income tax.
When doing your taxes, you will now if you have potential debt forgiveness income if your received the IRS Form 1099-C, Cancellation of Debt from your lender.

I’m broke. Should I consider a reverse mortgage?

You are over 62 years old, own a home and are struggling to pay the bills. An advertisement comes on TV that tells you that you can turn your home’s equity into “tax-free cash.” You learn that by signing up for a reverse mortgage, you will be able to stay in your home until you pass away — as long as you qualify.
It sounds like a promising option, but like anything promising, there are drawbacks.
Why would mortgage companies offer reverse mortgages? First, they bring in money. By only offering reverse mortgages to individuals over 62 years of age, they can expect a good return on many of their investments. Furthermore, they allow banks to immediately foreclose on a home after a death.
Yet, even though consumers must go through counseling before receiving a reverse mortgage, many do not understand the full implications. “It is not free money,” the government is now warning consumers.
Instead, the assistant director of the Consumer Financial Protection Bureau’s Office of Older Americans, Hubert H. Humphrey III states, “[Your home] is your nest egg. This is what you use when you don’t have any resources.” Unfortunately, people often decide to take the money out at age 62 and find that, years later, they need it and it is no longer there.
Take, for example, the story of a woman who was younger than 62 when she and her husband (who was over 62) applied for a reverse mortgage. Since she was under the required age limit, she was unable to sign the mortgage. When her husband passed away, the bank immediately foreclosed on the home, leaving her with very little, the money from the reverse mortgage already spent.
So, if not a reverse mortgage, then what? If you suffer from overwhelming debt, filing for bankruptcy may be an option for you. Most homeowners are afraid to file for bankruptcy because they believe they will lose their home and other possessions. Yet, in most cases, debtors are able to keep their homes during and after bankruptcy. This is because certain property is exempt from liquidation under state and federal bankruptcy laws.
If you are a senior facing significant debt, consider all of your options before deciding on a reverse mortgage. As Humphrey points out, a reverse mortgage should be considered as a last, and certainly not a first, option.
Learn more about debt relief options by visiting our pages on debt relief in Indianapolis.