The housing bubble from several years ago put a significant number of homeowners in a terrible position. Due to plummeting real estate prices, the market value of their homes fell below the corresponding mortgage amounts, thus classifying these homes as "underwater.”
The government established relief programs to help underwater homeowners refinance their mortgages (such as the HARP program), and provided tax relief through the Mortgage Forgiveness Debt Relief Act of 2015. This legislation waived taxes on reductions of debt through refinancing, or forgiveness of debt incurred from a short sale or foreclosure of your house.
Normally, these debt reductions are considered taxable income. It may seem odd, but it makes sense from an accounting perspective. If a bank accepted your house for $50,000 less than what you owed, thus forgiving $50,000 of your debt, it is no different from receiving $50,000 from some other source and using it to pay off that bill.
The Mortgage Forgiveness Tax Break waived debt forgiveness taxes up to a $2 million limit under two conditions: 1) that the house is your primary residence and 2) that the mortgage was an acquisition loan – in other words, the loan amount was used to build, buy, or improve the residence. This tax break was expected to provide temporary relief until the housing market recovered.
The housing market has begun to recover, but unfortunately, many homeowners are still significantly underwater. Congress has extended the tax credit through 2016. Thereafter, underwater homeowners may be in limbo – they cannot afford to sell their house, and may not be able to afford to stay there either.
Options are limited, but there are a few paths to consider:
- Insolvency Exclusion – If you can show that your total liabilities exceed your total assets, your debt forgiveness can be excluded from taxes to the extent you are in overall debt, on a dollar-to-dollar basis.
For example, let's assume a short sale of your house where $50,000 of your mortgage debt is written off. If you have assets of $400,000 and liabilities of $460,000, you have $60,000 of total remaining debt, which is more than enough to offset the $50,000 of mortgage debt forgiveness. On the other hand, if you had $430,000 in liabilities in the above scenario, you would have $30,000 of total remaining debt and could only offset $30,000. You still have to pay taxes on $20,000 worth of debt forgiveness.
- Ride Out The Storm – If you are in a position where you are underwater but can still make your payments, hanging on may be the best course of action. If you are fortunate, the housing market will rise quickly enough to bring you back "above the surface" so you no longer owe more than your home is worth. Refinancing may be an option at that point.
Unfortunately, there are only a few other options available such as foreclosure or bankruptcy, which carry other issues beyond the scope of this article. If you are still underwater and insolvency does not apply, keep close tabs on the news for reinstatement of the tax credit or a similar relief package, and hold on as best you can. Seek professional assistance to help evaluate your specific situation. If the tax break is reinstated, make it a point to know how long it will last so you don’t miss another opportunity to take advantage of it.