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Lenders May Give You a Break on Debt, But
Uncle Sam Might Not Be So Forgiving
There's a good news/bad news story if you're a borrower in
trouble with mortgage debt. The good news is that your lender
might be willing to renegotiate your loan to give you a break on
your payments or even forgive a portion of the debt. Foreclosure
is expensive and it's also bad publicity throwing people out of
their houses — lenders simply don't like to do it.
The bad news? The IRS is watching.
Lenders are required by law to report to the Internal Revenue
Service (IRS) any amount of debt forgiven to customers. That
means that unless you file bankruptcy or are otherwise declared
insolvent in court, you'll very likely owe federal tax on the
amount forgiven. Also, the IRS is watching if you're a homeowner
benefiting from something called a "short sale" — a
quick, speedy sale of your home to avoid foreclosure. At the
present time, those full proceeds would be a target for a bill
from Uncle Sam as well.
There is no question that thousands of Americans are in
trouble with mortgage debt, particularly those who might have
gotten low- or no-down payment loans that have actually raised
monthly payment amounts as interest rates have risen. Some of
these loans were structured in a way that as rates have gone
higher that the loans were sent into "negative
amortization" — where any equity is erased and the borrower
finds they actually owe more on the loan than the amount they
originally agreed to.
Add a potential tax debt to that situation and you see an
entire class of borrowers risking the loss of everything they
own.
Congress is trying to deal with the problem. Right now, a
bill in the U.S. House of Representatives entitled "The
Mortgage Cancellation Tax Relief Act of 2007" (HR 1876)
would amend the tax code to exempt debt forgiveness on principal
home mortgages from being treated as income. The legislation
would also help another class of troubled borrowers who
negotiate pre-foreclosure "short sales" or deeds in
lieu of foreclosure, or whose foreclosure proceeds are
insufficient to pay off their mortgage debt.
If you think you're running into this kind of trouble, it's
essential to speak with a CERTIFIED FINANCIAL PLANNER™
professional or a tax professional not only to estimate your tax
risk, but also to find out if there might be other approaches to
your individual situation. It's not wise to count on a
guaranteed break from Congress, particularly since the bill is
in the early stages.
Some things you might want to discuss with your tax expert or
financial planner:
Is refinancing an option? If you haven't made a late
payment and your credit is in relatively good shape, you may
still have the option to refinance instead of going for loan
forgiveness. Make sure you've checked your credit reports for
accuracy before you make this application.
Selling the house quickly. If you have some equity in
your home and your credit is still in relatively good shape, it
makes the most sense to get out from under your house payments
before you risk default or your payments go higher. You'll be
able to pull out some of your equity to put in savings to
reinvest in another home or condo someday.
Set a budget, rent cheap and rebuild your savings.
There's no shame in getting rid of a massive loan and starting
over. Granted, renting doesn't have the same tax advantages as
owning, but with proper planning, you can pick up the pieces and
start again.
June 2007 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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