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Posted April 6th, 2012 under Upside Down House Options

Debt Relief Act: For Debt Forgiveness on an Underwater Mortgage, the Time to Act Is Now

Tags: 1099c, debt forgiveness, underwater mortgage, Debt Relief Act

Debt Relief Act: For Debt Forgiveness on an Underwater Mortgage, the Time to Act Is Now

For the past few years, people with an underwater mortgage who've lost their homes to foreclosure or sold them through a short sale have enjoyed a great perk courtesy of the federal government and the IRS – they haven't needed to pay taxes on cancelled mortgage debt. But that benefit is set to disappear at the end of 2012.

People who've gone through a foreclosure or short sale are often surprised when they receive a 1099c form from their lender listing the amount of debt that has been forgiven (basically, the amount you owed that the lender said you didn't have to pay back). Lenders send out the 1099c because the IRS generally wants people to pay taxes on debt that's been cancelled. In the case of foreclosures, where there may tens or even hundreds of thousands of dollars in debt forgiveness, that could mean a significant increase in taxes for a homeowner who is likely already struggling.

The government saw the burden that taxing forgiven mortgage debt placed on people, which is why Congress passed the Mortgage Forgiveness Debt Relief Act. Under the Debt Relief Act, many homeowners who had mortgage debt forgiven between 2007 and 2012 don't have to pay income taxes on that cancelled debt.

Unfortunately, the Debt Relief Act is set to expire at the end of 2012. So if you're considering foreclosure or short sale, the time to act may be now, while you can still take advantage of the benefits of the Debt Relief Act.

But that doesn't mean you have until the end of this calendar year to get the ball rolling on a foreclosure or short sale. In fact, you need to get started right away, because you'll want to close escrow or finalize the foreclosure by December 31. Remember, a short sale or foreclosure can take months to complete. You need to start now to be sure you have enough time to complete all the paperwork and tie up any loose ends before the end of 2012.

A few things to keep in mind about the Debt Relief Act:

  • You must be currently living in the home to qualify. If the home isn't your primary residence (for example, it's a vacation home or rental property) the Debt Relief Act doesn't apply to you.
  • The Debt Relief Act allows you to exclude up to $2 million of forgiven debt.
  • The debt forgiven must be original purchase debt in order to be excluded from income tax.  
  • To claim the exclusion, you need to fill out IRS Form 982 and attach it to your federal income tax return when you file your taxes.

Whether you're protected by the Debt Relief Act – and whether a short sale or strategic default is the right choice for you – really depends on your particular circumstances. That's why it's important to go through our Underwater Homeowners Assessment and Action Plan to determine the best path forward for you.