You may opt for debt settlement with your mortgage lenders and may be lucky to get it reduced to your affordable limit. But there are lots of consequences, cautions and considerations to make before you actually go for it.
It is not only in the mortgage or a real estate loan any amount forgiven in any type of loan will tax liabilities and issues. Dent settlement actually will provide you with immediate relief from the financial stress but it will have a few serious effects in the long term apart from triggering a tax liability.
As per the current tax law, any canceled debt is considered as an income to the debtor and therefore it is legal to include this as part of the gross income or the income before taxes of the debtor.
The lender has the legal right and obligation to report about this waiver of the amount in the outstanding balance to the Internal Revenue Service as per their business code of conduct. They also have the obligation to inform you about such tax liability before you start negotiating for a reduction in your outstanding balance.
This is a report to the IRS is made in a prescribed template called Form 1099-C. According to the tax law, there are three remedies provided for excluding canceled debts from being considered to be taxable. These are:
- Exclusion in the case of insolvency
- For cases involving bankruptcy and
- For a few specific types of mortgage debt.
Apart from that, the mortgage exclusion is also considered for those debtors who are going through:
- A short sale or
- Having a portion of their principal reduced due to a loan modification.
In December 2007, Congress passed the Mortgage Forgiveness Debt Relief Act which provides tax relief to homeowners who have lost their house due to foreclosure or short sales. The law also exempts those people who restructure their mortgages going for a lowered principal amount. According to this law, these individuals can get their tax exempted up to $2 million of specific mortgage debts that are either canceled or settled by the lenders.
It is therefore recommended that you read the debt settlement reviews first to know whether you fall into any such categories and also to know the number of criteria that you may need to meet with to qualify for such exclusions.
Typically, any canceled mortgage debt that fails to meet these set criteria by the IRS may still be excluded if you can prove your insolvency or file bankruptcy. However, if you have a home equity loan or cashout or debt consolidation refinance, you will need to maintain a few extra bookkeeping. This will allow you to be sure that you can take full advantage of all the tax exclusions that are applicable in your case.
Qualifying under the Act
If you want to qualify under the Mortgage Forgiveness Debt Relief Act to be excluded from the income you will first need to know the types of mortgage debts. Ideally, there are two types of mortgage debt in the tax code:
- Acquisition debt and
- Home equity debt.
The significant difference between the two will determine which type of exclusion will apply.
- As for acquisition debt, it is the proceeds that are usually used to buy, build, and improve a principal dwelling substantially. Acquisition debt can be excluded from tax under the Mortgage Forgiveness Debt Relief Act.
- On the other hand, the proceeds of a home equity debt are used to buy, build, or improve the residence. A home equity debt cannot be excluded under the Mortgage Forgiveness Debt Relief Act but it can, however, qualify under the insolvency or bankruptcy exclusions.
There is another criterion as well. It is required as per the law that the house is used as the main home. This means it must be the principal place of residence of the borrower. Therefore, if you have any of the following you will not be exempted from tax liability in case of debt settlement:
- Second homes
- Investment properties
- Vacation homes or
- Rental units
However, reduced or canceled debts for those properties may qualify under the insolvency or bankruptcy exclusions.
The amount that can be excluded from a tax is the next thing to consider before you start your process to cancel your mortgage debt. Ideally, this amount of exclusion from income can be up to $2 million. However, if you are married and are filing a separate return this exclusion amount of income will come down to $1 million.
This amount is considered for a period from 2007 to 2016. After 2016, however, there is a new regulation imposed by the government. As per this regulation, you can still be excluded from tax for your debt forgiveness as long as the creditor and you enter into a binding written contract in which it is clearly mentioned about the cancellation of the debt clause and that too no later than December 31, 2016.
The reporting process
Reporting for canceled debts on the tax return must be done on your tax return if you qualify for such exclusions. Ideally, your creditor will submit Form 1099-C both to the IRS and to you mentioning the amount that has been canceled or reduced in box 2 of the form.
In case you gave up your home in foreclosure, a short sale, or another settlement process then the amount of the loan principal that was remaining unpaid after the settlement must be shown in Box 5 of the form along with the address of the property which the loan was for.
In addition to that, the fair market value of the property must be mentioned by the lender in Box 7. On the other hand, in a foreclosure situation, it is the gross bid price from the foreclosure sale that must be shown as the fair market value.
In your tax return, you must report canceled debts that are not excluded from Form 1040 Line 21.
With so much complication, it is recommended that you consult a tax attorney for that matter.
Kelly Wilson is an experienced and skilled Business Consultant and Financial advisor in the USA. She helps clients both personally and professionally in long-term wealth-building plans. During her spare time, she loves to write on Business, Finance, Marketing, Social Media. She loves to share her knowledge and Expert tips with her readers.