After the housing bubble popped and the economy fell into recession, many homeowners found themselves in deep trouble. They owed more on their house than it was worth and were unable to make their mortgage payments. Congress attempted to alleviate part of this problem with The Mortgage Foregiveness Debt Relief Act (MFDRA).
Under the federal tax code, forgiven debt is treated as income. Although at first blush this may seem unfair, there is sound logic behind it. A loan itself is not considered income because of the corresponding obligation to repay. Once that obligation is gone, then you are simply left with the debtor receiving money with no strings attached. Such money would have to characterized as income and would therefore be taxable.
Let's use some numbers to see this in action. Let's suppose a homebuyer took out a $200k mortgage to buy a home. Still owing $175k on the mortgage, the house's value dips to $150k. At that point the homeowner owes more on the house is worth and is unable to afford the monthly mortgage payments. If there was a short sale and the lender was to accept $150k as full payment of the $175k loan balance, then the homebuyer would have has $25k in debt forgivess.
Under normal circumstances, this amount would be taxable as forgiven debt. However, by passing the MFDRA, Congress chose not to treat this forgiveness as taxable income.
This law was set to expire December 31, 2012, and the result to distressed homeowners would have been devastating. However, Congress has just passed the American Taxpayer Relief Act of 2012, which extended the MFDRA through December 31, of 2013. Also included in the legislation were extensions to other tax breaks set to espire, including the mortgage interest deduction.
Here is the relevant language of the Act:
SEC. 202. EXTENSION OF EXCLUSION FROM GROSS INCOME
19 OF DISCHARGE OF QUALIFIED PRINCIPAL
20 RESIDENCE INDEBTEDNESS.
21 (a) IN GENERAL.—Subparagraph (E) of section
22 108(a)(1) is amended by striking ‘‘January 1, 2013’’ and
23 inserting ‘‘January 1, 2014’’.
1 (b) EFFECTIVE DATE.—The amendment made by
2 this section shall apply to indebtedness discharged after
3 December 31, 2012.
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