President Bush was horrified. The IRS had debt forgiveness as taxable income while people were losing their homes to short sales and foreclosures. At his Administration’s urging, Congress quickly passed the The Mortgage Forgiveness Debt Relief Act. Allow me to explain this.
People were losing their jobs during the recession. You can’t pay a mortgage without an income. The solution is to sell and get out but home prices had crashed. As a result, many people owed much more than their homes were worth.
Banks wanted to avoid foreclosures here because NJ processes foreclosures through the courts. This takes several years. Because of this system, it’s better for a bank to do a short sale. Let’s say a home was bought for $300,000 with a $250,000 mortgage. It sells today for $200,000. The bank forgives this shortage to avoid foreclosure. The IRS says this is taxable income. You are broke so now you’re in trouble with the IRS.
The Mortgage Forgiveness Debt Relief Act stops this. The IRS can not consider debt relief as taxable income. According to Personal Money Store, as a result, homeowners can do a short sale, loan modification or deed in lieu of foreclosure without owing the IRS anything. Originally covering 2007 through 2012 it was extended by Congress to include 2013. There is no reason to expect Congress to extend it again. It expires at midnight on December 31st.
Sellers owing more than their sales price must close by December 31st. There will be no debt forgiveness afterward so what the bank forgives will be taxable income.
This will also affect buyers of short sales. How it will affect you if you want to buy a distressed home, I can’t say but I’m sure the coming change will have an impact.
As a real estate agent I can only alert you to the coming change. If you need guidance on this, my advice is to consult with a tax attorney and your accountant.