Clock Ticking for Homeowners on Forgiven-Debt Tax Break

Article taken from Car.org

Greg Annis bought his downtown Pleasanton condo for $390,000 in 2007. Today, its value has fallen to about $200,000, while his income was cut 20 percent when his company instituted a weekly furlough day this year.

“It just doesn’t make financial sense to keep the condo,” he said.

Like many homeowners in similar situations, Annis tried to work with his lender and eventually decided to do a short sale – selling the condo for less than the $270,000 he still owes on it.

Annis felt an extra impetus to make it happen: A law that exempts “forgiven debt” from taxes is expiring at the end of this year.

“I heard through the grapevine about this law expiring,” he said. “I want to go ahead and do the short sale as soon as possible to make sure it happens in 2012 to take advantage of the law, in case it does not get extended.”

Before the housing downturn hit, “forgiven debt” on home mortgages could be taxed as income. For instance, if your lender lopped $50,000 off what you owed (a type of loan modification called principal reduction), if you short-sold the property for $50,000 less than your mortgage or if your lender foreclosed on a property worth $50,000 less than you owed, the $50,000 would be treated as income, adding up to a potential big bill for state and federal taxes.

But with millions of struggling homeowners in such situations, both the Congress and the California Legislature passed bills to exempt forgiven home debt from taxes.

But now the Mortgage Forgiveness Debt Relief Act of 2007 is due to expire on Dec. 31. The election-year Congress, already famously fractious, is not expected to act on it in 2012, although industry experts hope it could get extended next year.

“When the law expires at the end of this year, a lot of people could get hurt,” said Eva Rosenberg, an enrolled agent who runs TaxMama.com in Northridge.

Not everyone eligible

Even if the act eventually gets renewed, it doesn’t cover all homeowners.

“It applies only to the mortgage you originally got to acquire the home or to a refi used to improve the home,” said Stephen Moskowitz, a tax attorney in San Francisco.

Homeowners who did cash-out refinances and used the money for any other purpose than fixing up their house could still be on the hook for forgiven debt. The legions of people who refinanced during the boom days, using their homes as piggy banks, are not covered by the act, for instance.

For people in that situation – and for everyone if the act does not get renewed – one way to still avoid taxation is the insolvency exception, Moskowitz and Rosenberg said.

“Insolvency means your debts exceeded your assets the day before and the day after the foreclosure” or short sale or principal reduction, Moskowitz said.

“For example, assume that the day before the foreclosure (or other debt forgiveness), your home’s fair market value was $1 million, your mortgage was $2 million and your other debts, such as credit cards, were $8 million. Now we remove the asset and the liability of the house – and your debts still exceed your assets, so you are insolvent.”

Bankruptcy is also an option to dissolve the tax obligation, he said.

People with second homes used as vacation property who undergo foreclosure, short sale or principal reduction also are on the hook for forgiven debt with or without the law, Rosenberg said. Those with second homes rented out as investments should be able to offset the debt cancellation with their loss on the investment.

Extension possibilities

If Congress does extend the law for federal income taxes, California is poised to follow suit for state taxes, said Alex Creel, senior vice president of governmental affairs at the California Association of Realtors.

“Clearly nothing will happen on the extension this year,” he said. Even if Congress waits until well into 2013 or even 2014 to extend the bill, it could easily make the bill retroactive to Jan. 1, 2013, so no one would be left out in the cold.

“Admittedly that would put people in an awkward spot if they’re trying to do transactions in 2013 and Congress hasn’t acted,” he said. “They would be out there wondering if the extender would go through.”

There is another twist on the tax issue for California homeowners. Original purchase loans in California are “nonrecourse,” meaning the lender can’t pursue the mortgage holder for unpaid balances. Some refinances for the same amount as well as cash-out refinances where the money is used for home renovations, are also nonrecourse.

Debt forgiven on nonrecourse loans is already exempt from taxation.

As it turned out, Annis, the Pleasanton man doing a short sale, still has his original mortgage loan, so he would be off the hook for tax purposes with or without the debt relief act.

His bank finally approved the short sale late last week, seven months after he first applied.

“It’s a long process,” he said.



Carolyn Said is a San Francisco Chronicle staff writer. E-mail: csaid@sfchronicle.com