Many home owners breathed a sigh of relief this past year when they closed their short sale successfully, completed a Deed in Lieu or even just plain walked away from the mortgage that felt like a lead balloon around their necks; however that relief can turn into an even heavier weight if those who benefited from forgiven debt do not correctly file their taxes in 2013.
California is a non-deficiency state, the bank that was walked away from cannot seek compensation for cancelled debt on the purchase money loan of a foreclosed primary residence in California in most cases. Equity lines are another story unless there is documentation of using those funds to improve the home rather than buy personal property and etc.
No matter what the state says about short sales, foreclosures and etc., The IRS views Forgiven and or Cancelled debt as income……taxable income…..income taxable at a higher rate because it can shove the taxpayer into the next income bracket.
To help taxpayers during the economic crisis, the government passed The Mortgage Debt Relief Act of 2007, which generally allows taxpayers to exclude income from the discharge of debt on their principal residence; debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, short sale or Deed In Lieu all qualify for the relief under this Act. This special provision applies to debt forgiven in calendar years 2007 through 2012. And then Congress passed an extension of this act through 2013 in the Fiscal Cliff avoidance package earlier this year. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.
Good news right? However this is not automatic by any means, the taxpayer has to file the correct paperwork with their tax returns in order to have the forgiven debt excluded from taxation. That said there have also been changes to requirements for tax preparers this year that allows untrained parties to prepare tax returns – taxpayer beware that there is much more at stake in the tax filing for 2013 in general so this is a year to use either an Enrolled Agent or CPA to file your taxes.