How Will a Mortgage Bailout Affect a No Capital Gains Tax on My Primary Residence?
Lenders forgive mortgage debt when you modify your mortgage to reduce the amount legally required for repayment; when you short sale your home -- the sale price is less than the mortgage debt owed; or during a foreclosure -- forcibly repossessed and sold by the lender. Modifications can be permanent or temporary. In response to the 2007 mortgage crisis, loan modifications and short sales became common as lenders struggled to manage colossal amounts of delinquent mortgages. Forgiven debt may have capital gains tax or income tax consequences, depending on the circumstances.
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Capital Gains Tax and Real Estate
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Capital gains tax applies when an owner sells real estate for more than its cost basis; the cost basis is the sum of the purchase costs, home improvements and sale costs minus the accumulated depreciation. You can exclude up to $250,000 in gain -- or $500,000 for a married couple -- as long as you owned and lived in the home for a minimum of two of the five years prior to sale. You can also defer capital gains tax through a 1031 exchange -- buying a qualifying replacement property within strict time frames -- or mitigated with expert estate planning. When mortgage debt is forgiven, the Internal Revenue Service, or IRS, considers the amount forgiven to be income received by the debtor. Forgiven mortgage debt does not directly affect capital gains tax but may affect income tax.
The Mortgage Debt Relief Act 2007
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The Mortgage Debt Relief Act of 2007 eased the tax burden on homeowners in receipt of debt forgiveness due to short-selling a home, receiving a mortgage modification or losing a home to foreclosure. Prior to the Act, the amount of forgiven debt increased a borrower's taxable income by a like amount. The Act makes debt forgiven between 2007 and 2012, on most primary residence transactions, exempt from all taxes.
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What Kinds of Forgiven Debt are Covered by the 2007 Act?
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According to the IRS, the Act is only applicable to the forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. Your home must also secure the debt -- referred to as a qualified principal residence indebtedness. If you're married and filing separately, the maximum amount of indebtedness for your main residence is $2 million or $1 million. Prior to seeking a mortgage modification or a short sale on a non-owner occupied property, property owners would be wise to consult a tax professional regarding income tax consequences.
Eligibility
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Any homeowner with outstanding mortgage debt greater than current market value on a primary residence is eligible to attempt a short sale. However, different investors own mortgages and each investor has different approaches for forgiving debt. A homeowner who agrees to sell to a buyer for a price that will not pay the existing mortgage debt in full requires the mortgage owner's consent for the transaction to close.
A homeowner does not have to be delinquent on payments to qualify for a modification of mortgage terms. If a homeowner can document the mortgage owner's satisfaction that imminent default is "reasonably foreseeable," modification is possible. As with decisions on short sales, different investors have different standards for mortgage modifications. One commonality is that a homeowner must prove the ability to make the modified payment on time.
Forms and Tax Preparation
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When forgiving debt greater than $600, the lender issues Form 1099-C Cancellation of Debt. This form details the amount of forgiven debt and is necessary to complete federal tax return Form 982. Form 982 determines if the amount and type of forgiven debt is exempt from tax. Reporting debt forgiveness incorrectly could trigger a major taxable event. Recipients of debt forgiveness should Invest in the services of a professional accountant, rather than relying on a self-administered tax software program.
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References
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