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Foreclosure & Short Sale Mortgage Tax Break Expires

Bankruptcy Now the Only Sure Way to Avoid Taxable Penalties for Walking Away from Real Estate

mortgage tax break

Short Sales Now a Worse Deal than Ever

As reported by the Los Angeles Times here, the tax break extended to homeowners who have experienced a foreclosure or conducted a short sale of their primary residence under the Mortgage Forgiveness Debt Relief Act expired on December 31, 2o13, thanks to the inaction of the US Congress.

As a result, a surrender of foreclosing, underwater, or otherwise unwanted real estate through Chapter 7 or Chapter 13 bankruptcy is now the only sure way to avoid taxable liability for the deficiency balance owed on the terms of your mortgage note contract after the foreclosure or short sale (which, by definition, is a sale for an amount short of what you owe on the terms of your note).

What Was the Mortgage Tax Break?

The mortgage tax break eliminated the taxable penalty incurred by homeowners passing through a foreclosure or conducting a short sale based upon the amount of money unpaid on the terms of their mortgage note contract after the foreclosure or short sale.

To better explain, after most foreclosures and after every short sale, there is remaining what is called a “deficiency balance.” That is, in a typical mortgage agreement, it is the amount that you still owe, unpaid to the lending bank, on the mortgage note contract that you signed when you bought the house or property. The mortgage note is the document that you signed that obligated you personally to pay $X amount per month for 15-30 years. (The mortgage itself is a separate document that allows the lender to use the home or property purchased as collateral securing the mortgage note personal loan and to foreclose on the property should you default on the terms of the mortgage note—but the 2 items are separate documents with separate obligations!)

When a foreclosure sheriff’s sale/auction or short sale transfers ownership of the collateral real estate for less than you owe on the remaining mortgage note balance, the lender will charge off that deficiency balance. The “charge off” is not a forgiveness of debt! It is an accounting maneuver in which the lender reports to the IRS a certain amount of lost business income. The charge-off results in a 1099-C being mailed to you by the lender, and the IRS considers that charge-off balance to be “taxable income.”

It was that taxable income balances that the Mortgage Forgiveness Debt Relief Act prevented you from having to actually pay taxes on—so long as the charge-off was for a first mortgage on a primary residence (it never applied to rental or investment or commercial properties) or for secondary mortgages or home equity lines of credit in cases where all of the money borrowed was utilized for the purchase or improvement of the collateral real estate (it never protected you from taxable liability in cases where the homeowner used HELOC funds to consolidate credit cards or fund a business enterprise).

Now, unless Congress acts to reinstate this mortgage tax break and make it retroactive to January 1st, it applies only to foreclosures or short sales completed before December 31, 2013. Ongoing or future foreclosures or short sales should rightly cause homeowners serious concern with regard to taxable consequences.

Why Is Bankruptcy Now an Even Better Option Than Before for Surrendering Property?

Easy answer here: bankruptcy is legal insolvency. The discharge of debt and/or surrender or property in either a Chapter 7 or Chapter 13 bankruptcy is therefore a non-taxable event.

Any 1099-C for discharged debt (which includes mortgage note liability for surrendered property) that you receive during or after a bankruptcy proceeding will have no taxable effect (though you will still want to give it to your CPA when you have your taxes done so that it may be accounted for properly).

Bankruptcy, with its predictable chances of successful discharge, predictable timeframe, lack of need to negotiate the surrender of real estate with creditors, and guaranteed non-taxable liability, was always a better option for walking away from real estate than a short sale or foreclosure, particularly in states like Michigan which allow, on top of the potential tax consequences, deficiency debt to continue to be personally collected from the homeowner afterward.

Now, however, no struggling homeowner should consider a short sale without first consulting an experienced bankruptcy attorney to review their complete options.

If you are a Michigan resident and would like to explore your options for a Chapter 7 or Chapter 13 bankruptcy with an experienced Michigan bankruptcy attorney, please contact us at (866) 674-2317 or click the button below to schedule a free, initial consultation.

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