Options for Underwater Homeowners

If you close on your underwater mortgage before 12/31/12 and your lender forgives your debt, you don’t have to pay a phantom income tax.

We’ve received quite a number of letters recently from readers that are trying to determine their best options given their status as underwater homeowners. Some of these letters clearly indicate that some of the homeowners are quite able to make their payments but view those payments as a waste of money. Some people have moved out of their homes due to job transfers or new job opportunities and have continued to make their mortgage payments, while others are struggling and don’t know where they can find the money to make their next mortgage payment.

As we approach the election and the end of the year, all of these readers trying to get rid of their primary homes have one thing in common: taxes. If you are underwater with your mortgage and your lender agrees to let you off the hook for the balance of what you owe the lender, you won’t owe federal income taxes on that so-called phantom income or gift from the lender to you if you close on the sale by Dec. 31 of this year.

It does not matter if you disposed of your home through a short sale, foreclosure, or deed-in-lieu of foreclosure. It won’t matter what your circumstances giving rise to the sale were. If your lender waives any claim for the money, where you would still owe the lender after the short sale, foreclosure or deed-in-lieu, that money is generally taxable to you.

A couple of years ago, Congress decided to give a break to homeowners who were losing their homes from the great real estate bubble from the additional tax hit they would sustain when their lenders forgave part of the debts they owed.

Now, with a Congress unable to do much, a federal government annual deficit well above a trillion dollars and an ever increasing federal debt, we don’t know if there will be much appetite to give homeowners a break.

To put things in perspective, if you purchased a home at the height of the real estate bubble in some of the fast growing real estate markets, you might have seen your home value drop in half. If you purchased a home for $300,000 with a mortgage of $240,000 and your home is now worth $150,000 and sell that home in a short sale, your lender may forgive $90,000 of debt.

That $90,000 will be added to your income taxes and you will most likely climb the income tax rate ladder quite a bit. At higher incomes, you pay a higher rate of federal income taxes. You also may have to pay a higher state income tax rate depending on your state.

It’s possible that the $90,000 “gift” from your lender could end up costing you upwards of $30,000 in additional income taxes. So not only would you have lost your initial deposit in the home of $60,000 but also you’d take an additional hit of $30,000 on your income taxes. Until Dec. 31, 2012, you’re safe, but on Jan. 1, 2013, all bets are off.

So to homeowners facing foreclosure, a short sale or deed-in-lieu of their primary residence, you all have in common the goal to close your deal by the end of 2012.

Given the timing that some short sales take, you may be in for a surprise. Some short sales have taken months, if not years, to complete. In addition to the sale issues, you also need to keep abreast of the impact a sale of your home will have on your finances, including income taxes.

You need to plan ahead to avoid any additional unpleasant surprises.


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