Debt forgiveness is a beautiful thing both emotionally and relationally. The mathematics of it are not so friendly. Why? Because of the IRS and because the Tax Relief act of 2007 is coming to an end.
How The Money Flows When Borrowing
When you buy a house with a loan, a lender agrees to purchase the item with their money with the understanding that if you don’t pay them back, they get to take whatever has secured the note. In this case, your house is the security. So, if you don’t pay them, they can sell the house and recover their investment, or a portion thereof.
Since the money used to purchase the home isn’t really handed to you, the buyer, it doesn’t feel like income, and as long as you pay back the note, it won’t be considered income. But, if the lender decides at any point to forgive you of the balance of the remaining note, it would be the same mathematically had they simply written you a check to buy the house directly from the seller. In that case, the money would have come directly to you and would be considered income.
The Idea of Phantom Income
So, when debt is forgiven, there’s a sort of “retroactive” income (many people call it phantom income) that is applied to you in the form of a form 1099-C (Cancellation of debt) statement. If you don’t know now, you’ll soon know that a 1099 is a tax form that declares income.
Why does the lender issue the 1099-C? Because every money transaction has two sides to it. The lender is taking a loss which they must report to the IRS in order to deduct it from their taxable income. Their loss is your gain.
What? Yep. Their loss is your gain. Think about it. Their original plan was to make a boat load of interest (their gain) over 30 years or 15 years, or whatever, as you paid back your loan. They weren’t planning on losing their money. But, since they have lost it, they get to deduct it. Since they’ve forgiven you, the balance forgiven becomes income to you in the tax year in which the forgiveness takes place.
Yikes! What Does That Mean?
It means, in short, that you may or may not owe income taxes at your tax rate on the forgiven debt. Here’s an example:
You buy a home for $300,000 and you faithfully pay for a year. During that year, the value of the house falls to $225,000 and you lose your job. You can no longer make your payments, and you go into default. Your REALTOR®, who happens to be an experienced short sale agent in your area, helps you sell your house for market value, leaving you with an agreement with your lender to write-off the remaining $75,000.
Well, the bank isn’t just going to toss that money aside without a tax benefit, so they file a 1099-C to show that you were the original beneficiary of the money that was used to purchase your home.
Suddenly you’re staring an additional $75,000 in annual income for the year, which may or may not be taxable based on your current circumstances.
Enter the Tax Relief Act of 2007
In 2007 a law was passed that offered protection against owing income taxes on forgiven debt provided you met certain conditions. That law expires on December 31st of THIS YEAR.
Why is this important?
If your home is underwater, and you’re experiencing financial hardship, you have a little more than 8 months to list, market, and short sell your home to avoid paying income tax on debt forgiveness. Unless our powers that be extend this provision, short sales, many of which are inevitabilities that home owner’s don’t yet realize due to emotional paralysis, will become very costly to the home owner.
Are you hearing me? Some of you have been sitting on the decision to short sale for a few years now…and every penny you’ve spent on your house is lost…
…the longer you wait, the more it will cost you. if you don’t act quickly, it may cost you even more that you ever imagined.
Thus, the importance of acting now must be emphasized.