Columnist: IRS Penalizing Those Hoping to Escape Florida Mortgage Foreclosure

For homeowners around the Sunshine State who are seriously delinquent on mortgages and hoping for relief, the IRS has bad news:

If your Florida mortgage company agrees to modify your loan and forgive any of your debt, you could owe income tax on the amount forgiven.

Think of it as the tax code’s “kick-’em-while-they’re-down” rule, writes syndicated columnist Kenneth Harney in his latest investigative report.

When personal debts are canceled by a creditor, the amount forgiven is treated as ordinary income under the Internal Revenue Code unless the taxpayer is insolvent or bankrupt.

Worse yet, the Florida mortgage lender is required by law to report the amount canceled to the IRS.

This is especially bad news for the growing numbers of subprime, or bad credit Florida mortgage borrowers who are finding themselves “upside down” in the current real estate market.

In other words, they owe more on their mortgage than the value of their house, thanks to noxious combinations of zero down payments, declining property values and hefty payment increases they can’t afford.

In many cases, after a homeowner negotiates a home loan modification agreement with her lender, they assume they are done with the matter.

But a year later, the IRS may come after them, wanting a large tax payment on the amount the lender forgave - a tax bill that may be equal to their annual income.

The homeowner never had actually received that income in any tangible way; he or she couldn’t deposit it in her bank account. But under federal law, the IRS had every right to come after her for unpaid taxes.

Similar situations are likely to pop up around the state and country in the coming year as lenders bend over backward to modify thousands of troubled loans before they go to foreclosure.

Proposed new, bipartisan legislation on Capitol Hill could soften some of the impact on financially stressed homeowners, however.

The Mortgage Cancellation Tax Relief Act of 2007 (HR1876) would amend the tax code to exclude debt forgiveness on principal Florida home mortgages from treatment as income.

The legislation could assist many other homeowners in financial trouble who negotiate pre-foreclosure “short sales,” deeds-in-lieu-of-foreclosure and whose foreclosure proceeds are insufficient to pay off mortgage debt.

Short sales are increasingly commonplace. Say you are seriously behind on your mortgage payments and a loan modification or rate reduction won’t solve the problem because you’ve just lost your job.

As an alternative to foreclosure, your lender might suggest a quick sale of the house, often to an investor who’ll buy it as-is at a discounted price.

If the short sale proceeds are $10,000 less than the outstanding home mortgage loan balance, and your lender agrees to forgive that amount, the bill would allow you to obtain that relief tax-free.

Under current law, by contrast, the home loan lender would be required to report the $10,000 in phantom income to the IRS. Ditto if you went to foreclosure and the sale proceeds yielded $10,000 - or $50,000 - less than the outstanding debt owed to the lender.

Proponents of the debt-relief reform bill argue that short sales, Florida mortgage delinquencies and foreclosures are painful situations for most homeowners, and there’s no public policy purpose served by smacking them with tax penalties that make things even worse.

In the case of below-market short sales, for example, most homeowners have already suffered sizable capital losses that are not tax-deductible.

They’ve lost thousands of dollars in equity. Why pile on?

The outlook for the bill: It’s currently before the House Ways and Means Committee, Congress’ primary tax legislative body.

Since most of the majority Democratic housing and banking committee leaders have called upon banks and mortgage companies to work out solutions to keep troubled homeowners out of foreclosure, a bipartisan tax fairness bill like this one should have a reasonable chance of passage.

SOURCE: San Jose Mercury-News