American Taxpayer Relief Act of 2012
On January 1st, 2013 the U.S. Senate overwhelmingly passed legislation to avoid the so-called “Fiscal Cliff” by a vote of 89-8. The bill, referred to as the American Taxpayer Relief Act of 2012, avoided draconian sunset tax provisions that were scheduled to take effect after 2012 under the Bush-era tax cuts. The U.S House of representatives quickly approved the bill by a vote of 257-167. The Taxpayer Relief Act was immediately criticized as falling short of the great tax bargain envisioned during the November elections. While political pundits mostly panned the legislation for being mostly a stop-gap measure, the legislation is absolutely necessary for the recovery of the U.S. housing industry. Specifically, the Taxpayer Relief Act includes an “extender” to the Mortgage Debt Relief Act of 2007, a provision that allows struggling homeowners to avoid paying taxes on the cancelation of indebtedness income following a foreclosure, short sale or loan modification of their primary residence.
Extension of The Mortgage Debt Relief Act
The Mortgage Debt Relief Act of 2007 enables homeowners to exclude any canceled debt from being taxed as income as long as the indebtedness was incurred on your “qualified principal residence.” Had the extension not been granted, millions of distressed homeowners would have had less incentive to pursue a loan workout or short sale because the forgiven debt would have been taxed as income. Admittedly, the extension of the Debt Relief Act is not the panacea to the sluggish home prices and poor quality of inventory, but the tax relief will undoubtedly aid the housing recovery in 2013 because it will allow homeowners who struggle to keep up with their mortgage payments, after having already experienced declining home values, to avoid further financial penalties following a foreclosure, short sale or loan modification.
Cancelation of Debt as Taxable Income
In general, when a creditor cancels debt, such as unpaid balances on student loans or credit cards, the forgiven amounts are treated as ordinary, taxable income under the Internal Revenue Code. Following a short sale, the Debt Relief Act exemption is triggered when a lender agrees to forgive the homeowner from paying back the remainder of their loan in consideration of a short payoff of their primary residence indebtedness. This amount, known as the loan deficiency, would otherwise be taxed as ordinary income. The entire short sale sale industry, and the current housing sector for that matter, is largely dependent upon the tax exemption afforded by the Mortgage Debt Relief Act because the IRS does not treat the canceled debt as income. As a result, Congress’ last minute agreement to avoid the fiscal cliff will directly aid the housing recovery in 2013 because homeowners will still be able to modify their mortgage and short sell their primary residence without incurring additional tax liability.
Qualified Principal Residence Exception
It is important to point out, however, that the Mortgage Debt Relief Act does not provide tax relief if you short sell an investment property or a home that is no longer your qualified principal residence. Qualified principal residence indebtedness is limited to forgiven or canceled debt for loans under $2 million used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. Thus, even debt incurred as a result of a refinance loan will qualify for this exclusion, but only to the extent that the principal balance of the old mortgage would have qualified. In other words, if the debt forgiven was a result of a short sale of your qualified principle residence, and you never refinanced, you will qualify for the tax relief. If, however, you took out a refinance loan on your principal residence, you will qualify for tax relief only up to the principal amount of the original mortgage. This is a very important consideration and one that is often overlooked by many so-called short sale experts.
Not all States Recognize the Debt Relief Act
As previously stated, the most common tax exemption following a short sale is the qualified principal residence exception of the Mortgage Debt Relief Act. Some recourse states, however, such as Massachusetts, do not recognize the Mortgage Debt Relief Act. Homeowners, therefore, need to seek out other recognized tax exemptions, such as proving insolvency or filing for bankruptcy, in order to avoid being taxed on the debt forgiveness following a short sale. On the other hand, some short sale experts and tax professionals contend that short sales never result in tax liability, regardless of where you live or whether it is your primary residence, so long as your taxes are prepared properly. As a short sale facilitator, I don’t even attempt to speculate on the tax consequences of a specific short sale transaction. I always make certain that the seller is represented by an experienced attorney as well as encourage them to seek the advice of a licensed tax professional. In general, I always assume that a short sale will result in tax liability unless the homeowner qualifies for one of the recognized tax exemptions. Regardless, even if you think you qualify for a tax exemption, all homeowners should consult with a licensed attorney and a tax professional prior to agreeing to a short sale.
The Debt Relief Act and Short Sales in 2013
Even though many sellers don’t qualify for the tax relief, the extension of the Mortgage Debt Relief Act is absolutely necessary for the housing industry to recover in 2013. By extending the Debt Relief Act, the government is sending a message to lenders, distressed homeowners, and real estate professionals that short sales are the preferred method to assist homeowners in getting rid of a mortgage they can no longer afford. The tax exemption, along with lender incentives, encourage homeowners to be proactive about avoiding foreclosure. Fewer foreclosures will help stabilize home prices and less homeowners in default will mean a decrease in the shadow inventory. Admittedly, not all professionals agree as to whether a short sale results in tax liability, and the waters can become rather murky the more you navigate through state-specific laws, recourse jurisdictions and the sale of investment properties or non-purchase money mortgages. If nothing else, however, the extension of the Debt Relief Act will enable homeowners to sell their primary residence at a loss without incurring thousands of dollars in tax liability while at the same time allow lenders to get rid of their non-performing loans.
About the Author: Andrew Coppo of Greater Boston Short Sales, LLC (GBSS) is Massachusetts’ leading short sale negotiator. GBSS assists buyers, sellers, real estate agents and attorneys with getting their short sales closed. Contact us today if you are a homeowner facing foreclosure or a Realtor seeking assistance with a short sale transaction. GBSS is a MARS provider. Please read our disclaimer HERE.
If you are considering a Massachusetts short sale, and would like a free short sale consultation, please call Andrew Coppo at 617-264-0376 to schedule a free short sale consultation.
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