Kelly: Mortgage relief won’t face tax – if you can get it, that is

Due to the decline in housing prices, many home sales are “short sales” in which the purchase price offered by the buyer is less than the mortgage amount owed by the short-sale seller.

When a lender agrees to a short sale, it can either retain the ability to collect from the short-sale seller the amount of mortgage debt owed by the seller that is not satisfied by the purchase price, or it can discharge all or a portion of the unsatisfied debt amount.

If a lender discharges debt, it reports this discharge of debt to the Internal Revenue Service on a 1099-C Cancellation of Debt Form. The issuance of the 1099-C allows the lender to take a tax deduction for the loss represented by the amount of debt discharged, and this same amount of debt discharged becomes taxable income to the short-sale seller.

A lender is now able do one or the other, not both. Some consumers are confused how lenders can collect the mortgage debt owed after agreeing to the short-sale price. Others feel they are protected from the practice under a law passed five years ago.

In December 2007, Congress passed the Mortgage Forgiveness Debt Relief Act. This law provides some relief for homeowners who lose their house through foreclosure or short sales, or who restructure their mortgages with a lower principal amount. The law enables individuals to exclude from tax up to $2 million of certain mortgage debt canceled by lenders.

According to Nathan Gordon, government affairs director for the Washington Association of Realtors, some short-sale negotiations do not include language of the forgiveness – that the difference between what is owed and what is paid will actually be “forgiven.”

“In cases where, for whatever reason, that is not negotiated as part of the short sale, a recent court case ruled that even if the bank gives the borrower a 1099 they still can go back after the borrower for the remaining amount for up to three years, because both the bank and the borrower have up to three years to amend their IRS returns,” Gordon said.

“The Mortgage Forgiveness Debt Act really doesn’t speak to this specific point,” he said. “The MFDA merely says that until the end of 2012, if you do get a 1099 from the bank as a result of a short sale, that you do not have to pay taxes on the forgiven amount even though it is technically unearned income.”

Gordon said the distinction to keep in mind is that a 1099 does not necessarily indicate that the debt is forgiven, just that, for the time being, the bank is writing it off as a loss on their taxes. WAR is backing legislation that would clarify all short-sale terms for the homeowner.

“Should our bill (SB 6337) pass, that would all change and a 1099 would be a concrete declaration of forgiveness of the short sale,” he said.

While you don’t have to pay tax on the forgiven amount, there is no relief or tax deduction for selling your home at a loss. There is no benefit for folks who bought at the peak or made expensive remodels, then had to sell in a hurry and actually got less for their home than the cash they had invested in it.

Uncle Sam will not let you show a loss on your primary residence if you sell for an amount less than the purchase price. If you’ve planned on writing that down on your 2011 federal return, think again.