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IRS Provisions on Cancellation of Debt and its extension

In a recent survey, Realty Trace reported that a total of 193,059 U.S. properties were in some stage of foreclosure or bank-owned (REO), which were sold during the third quarter of 2012. This saw an estimated increase of 21 percent from the previous quarter, but down by about 3 percent from the third quarter of 2011. All the more reason perhaps for people to be worried about whether the IRS Provisions on Cancellation of Debt on Primary Home would be extended or not. But now that the act has been extended till 2013, it brings relief mostly to those people who are selling their home through a short sale and may have been faced with tax liabilities if the act did not come into place.

Normally there was supposed to be a tax liability for the debtor and his sale of property used as mortgage for partial of complete relief from debt. Under which, debt that is forgiven or cancelled by a lender is to be indicated as income on your tax return and is therefore taxable. Subsequently when such an obligation is forgiven, the amount you received as loan also falls under the taxable category, more so because you no longer have an obligation to repay your lender. In such cases, the lender is required to report the amount of debt that has been canceled towards you.

But thanks to the Mortgage Forgiveness Debt Relief Act, such tax liabilities are reduced as the act allows you to exclude certain cancelled debt on your principal residence from such income, as

  • Debt reduced through mortgage restructuring
  • Mortgage debt forgiven in connection with a foreclosure

In the year 2007 following the American housing market collapse and mortgage crisis that followed, the U.S. Congress enacted the Mortgage Forgiveness Debt Relief Act of 2007 apart from being aimed at stabilizing the economy it gave relief to numerous debtors. Perhaps why, debtors and financial pundits all across the US are keen to understand the impact and the reactions of the law being extended in 2013.

The law is applicable to those who have property that is used as security for a debt and which might have been foreclosed by the lender either in full or partial clearance of the debt. As a result the debtor is considered to have sold off the property, which in turn makes one liable for tax implications. This distress sale might generate either a gain or a loss, and in some cases cancellation of debt income too. Thus a mortgage restructuring like reduction of principal amount, helps in reducing your debt. This is why the IRS Provisions on Cancellation of Debt on Primary Home and its extension till 2013 is indeed welcome.

The acts includes provisions under federal law which of course subject to certain conditions, allows a taxpayer to exclude, the discharge of debt on their principal residence from their federal taxable income which would otherwise have been required to report. Special federal rules which relate to qualified principal residence apply to debt that has been reduced through mortgage restructuring, as well as to mortgage debt, which is forgiven as a result of foreclosure. The credit crisis and the number of taxpayers, who are deeply indebted, benefit largely since the IRS has instituted changes concerning tax liens. As a result, when the debt is repaid, the IRS grants the taxpayer a lien withdrawal, wherein the IRS not only releases the lien, but also removes it from the credit ratings of the debtor. This is done so that the credit score of the person is not affected. Also the IRS can grant a lien withdrawal even if the taxpayer has not fully repaid the debt, but only in part. The amount should preferably be less than $25,000 and the debtor agrees to a direct debit from his bank account.

A few important necessities in order to avail full benefits of the act are-

  • The maximum amount that can be treated as qualified principal residence indebtedness is $2 million from the time the loan was forgiven.
  • The debt amount that has been forgiven to you must be reported on Form 982 and this form should be attached to your tax return.

The relief act’s extension till 31st December 2013 is not only vital to the debtors, who are already under financial duress but will also give a boost to the recovering housing market. For more in-depth understanding and relief measures from debt, please feel free to consult Shah Peerally, attorney at law