Mortgage Debt Forgiveness Relief Act Not Extended – And Why That Isn’t Bad News!
MDFRA expired December 31, 2013 and has not been extended to 2014; although an extension is being considered by Congress.
In December of 2007, Congress passed the Mortgage Debt Forgiveness Relief Act (MDFRA) to provide relief to struggling homeowners potentially facing crippling tax liability. When the United States Senate and House passed the 2012 American Tax Payer Relief Act it extended the Mortgage Forgiveness Debt Relief Act (MFDRA) through December 31, 2013. To date, MDFRA has not been extended into 2014.
Congress is considering an extension of the MDFRA, and although there is bi-partisan support to extend, there is nothing definitive to report as of this writing. Many people are very concerned about this; however, it is important to note that there are other exclusions which are not subject to expiration which can be more helpful in reducing or eliminating the tax impact of cancellation of debt income.
Although MDFRA has not been extended, it is possible to exclude canceled debt from income to the extent you were insolvent immediately before the cancellation. Often times, these other exclusions are more helpful, easier to document, and less difficult to qualify for.
Why Isn’t This Bad News for potential Short Sale Sellers?
The Internal Revenue Code provides for several exclusions pursuant to Section 108, which can help taxpayers reduce or eliminate the tax due as a result of the cancellation of debt. Most commonly, the insolvency exclusion can be claimed, which exempts forgiven debt for a taxpayer, to the extent of their insolvency. Insolvency is the difference between the taxpayer’s outstanding liabilities and the fair market value of all assets held on the date of sale or debt forgiveness. To the extent that the taxpayer’s liabilities are greater than the value of the assets, that difference can be used to exclude cancellation of debt income from taxable income.
For example, assume the taxpayers liabilities, including the mortgage debt forgiven, total $500,000 and the fair market value of all the assets, including the property sold, total $400,000. The difference ($500,000-$400,000) of $100,000 is the extent of their insolvency. That means up to $100,000 of 1099-C income can be excluded from taxable income. Assets used in this calculation include creditor protected assets, such as retirement accounts. A borrower should never assume that they qualify for this exemption by virtue of the fact that there is negative equity in their home. To determine eligibility for the insolvency exclusion, a detailed analysis of a taxpayer’s assets and liabilities need to be performed. Unlike the exemption provided by the Act, this exclusion is available for investors.
The insolvency exclusion does not require the taxpayer to have ever lived in the property. The taxpayer also is not required to prove how the money borrowed was used, which can be especially problematic when sellers have owned the property for a long time. The only documentation the taxpayer must gather is the support to show the value of the assets and balance of any debts or liabilities included in the insolvency calculation. This can be much easier to gather and can be much less intimidating to sellers. The problem is, many of them just don’t know about it!
Many potential sellers have been paralyzed by fear and confusion regarding the process and the tax impacts, which have caused them to not take action. Alternatively, some sellers have mistakenly believed that they will avoid the liability for reasons that are inaccurate. The following are some issues that result from those beliefs.
Many people intend to advise their lender not to issue a 1099-C to them. However, lenders are required by law to report on Form 1099-C any release of debt greater than $600 and have no discretion to withhold such information. The resulting tax liability occurs upon the release of loan obligation, not upon the issuance of the 1099-C. Not only does the lender have a reporting obligation, but the borrower must also report this liability on their tax return for that year. Failure to do so can result in a 25% underreporting penalty and an increased audit period from three to six years.
Some borrowers believe that foreclosure may allow them to circumvent tax liability, but release of debt may occur following completion of a foreclosure. Again, the borrower has no ability to request the lender not issue the 1099-C, and if the lender chooses to release the debt following the foreclosure action, either on its own accord or in response to post-deficiency negotiations, the debt forgiven will likely be much larger and the incidental tax liability much greater due to the additional costs and fees that accumulate and grow the balance of a loan throughout a foreclosure action.
Borrowers also believe bankruptcy to be a potential solution to tax liability. This may be accurate depending upon when bankruptcy is filed. Income tax liability is not typically dischargeable and if the forgiveness of debt occurs prior to the bankruptcy filing, it will likely remain. Therefore, if the seller fails to complete the bankruptcy prior to the short sale debt forgiveness would result in the 1099-C income being taxable and not dischargeable in the bankruptcy.
Tax consequences resulting from short sales, loan modifications, and foreclosures are fact specific and should always be evaluated by a professional. In many cases, tax planning can help a seller legally avoid or minimize the tax consequences of their transaction. If the seller proceeds without planning for the tax impact of the transaction, they are often unpleasantly surprised with the outcome.
For questions regarding the cancellation of debt and insolvency issues, consult with a tax attorney or Certified Public Accountant familiar with IRS requirements.
Koontz and Associates PL assists clients throughout Florida in legal matters relating to Residential and Commercial Real Estate (including short sales), Business Law and Tax Law. From their Sarasota offices they serve clients in Sarasota County, Manatee County and throughout Florida.
The information provided in this article is for general informational purposes only and nothing contained herein should be taken as legal advice for any individual case or situation. The information contained in this article is not intended to establish an attorney-client relationship.