In 2007, the Federal Government passed The Mortgage Debt Forgiveness Relief Act as a means of enabling upside down property owners to possibly avoid paying income tax on unpaid loan debt after a foreclosure, short sale, or even a loan modification. The Act was passed in response to the collapsing real estate market as we entered what has come to be called the Great Recession. Although it originally was set to end in 2009, the severe depth and longevity of the economic crisis caused the Act to be repeatedly extended to the end of 2013.
In similar fashion, most States, including California, adopted similar laws to exempt forgiven debt from State taxes. Although these laws were in part modeled on the Federal Act, they were separate and had separate termination dates.
Significantly, no further action to extend the federal Act for 2014 was taken until December 26, 2014, which only extended the Act for 2014. California failed to join in this process and so California provided no relief after 2013.
For 2015, a similar lack of action was occurring although several Bills were introduced in Congress to extend the Act through both 2015 and 2016. President Obama further voiced his desire for this two year extension but throughout almost all of 2015, nothing happened and the Congressional Bills went nowhere. Finally however on December 18, 2015, Congress and the President agreed on and passed a 2016 Federal Spending Bill containing some 2000 pages of spending items. Buried deep within the Spending Bill was the extension of the Act for 2015 and 2016.
So, what this means is that people who have experienced Debt Forgiveness in 2015 or will experience it in 2016, may be able to avoid having to pay income tax on the forgiven amount. Put into real terms, this means that a person who sells their home for $100,000 less than they owe may avoid adding this amount to their overall income and paying income tax on the whole amount which could be up to $35,000 or more!
Unfortunately, California has not agreed to any further extension since its tax relief ended in 2013. Two things to remember:
1. Not all forgiven debt is protected by the Act. It is limited to debt incurred to acquire or make improvements to your personal residence (typically where you have lived three of the past 5 years); and
2. The Act is only one of several exemptions that may apply. The following may also be usable to avoid the tax on forgiven debt:
– Purchase Money Debt on your Personal Residence
– Capital Loss Offset on Investment Property
If you have or expect to incur forgiven debt, we recommend that you consult a knowledgeable real estate attorney to determine what exemptions may apply to your situation. Some exemptions require action by you before the debt forgiveness occurs, ie: before the property is sold or foreclosed. Our friends at BPE Law have counseled thousands of upside down owners on these and other real estate issues and they have a $300 flat fee consultation for this purpose. If you would like such a consultation with one of their knowledgeable attorneys, please call BPE Law at (916) 966-2260.
This article is not intended to be legal advice, and should not be taken as legal advice. Every case requires review of specific facts and history, and a formal agreement for service.
Source: BPE Law