This question is presented often by clients who are facing a foreclosure and are not sure how the foreclosure might impact them in the future. That is one of many reasons why speaking with an experienced attorney before making any decision regarding a foreclosure is strongly recommended.
The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately).
Therefore, the answer to the question posed above is “no”, you will not be taxed on your foreclosed home (unless the amount being forgiven is greater than $2 million for joint filers or $1 million if married filing separately). However, the reason this act is important in today’s housing market is that, without the act, debt reduced through mortgage modifications or short sales qualifies as income to the borrower and is taxable. This legislation enacted in 2007 is set to expire on December 31, 2012. If the legislation is not extended, then it would require homeowners to complete a short sale or modification prior to year’s end in order to avoid a tax consequence.
President Obama’s fiscal year 2013 budget proposal includes an extension of the Mortgage Forgiveness Debt Relief Act of 2007. The administration is proposing an extension that would apply to any amounts forgiven before January 1, 2015. However, if you are like me, you should remain skeptical and check back for an update on whether or not Congress actually extends the Mortgage Forgiveness Debt Relief Act of 2007.