I remember 10 years ago there were very few foreclosures, but in the last four years, the landscape in foreclosures and short sales has shifted. In every neighborhood there are homes that have been foreclosed on and almost always there is a handful that have been through a short sale because of decreasing home values.

Before the crash of 2008, if you had your home foreclosed on or sold your house for less than you owed on it, the lender could do one of a couple of things: 1. they could go after you for a deficiency judgement and you would owe them the difference or 2. they would issue a 1099 for the difference and you would have to pay taxes on it. Either prospect did not look fantastic. For your information, this provision also applies to debt forgiven through a credit card company and other types of loans.

As part of the Mortgage Forgiveness Debt Relief Act, debt reduced through mortgage restructuring or any difference between what you owe the bank and what they sold your house for as part of a foreclosure was decided to not be income and was not taxable. The provision applies to up to $2.0 M in debt. The other side of the coin is that any loses that you have during your foreclosure are not eligible to be claimed as a loss on your tax returns. It only applies to your principal residence, and from what I know it does not apply to investment properties. If you had a portfolio of investment properties and lost them to foreclosure, then you may have to report the difference as income.

While this has been a needed break for families going through foreclosure, you need to know that the time frame covered by the Act is 2007 to 2012. Yep, that means unless Congress acts and extends the provisions of this Act that if you are foreclosed on after 2012 that you may have to pay income taxes on the loss amount. I can guarantee that your bank will send you a 1099, which will also be reported to the IRS. There will be no way to get out of paying taxes to Uncle Sam on this.

What does this mean to you? If you are one of the thousands of homeowners who are not making their payments hoping that their lender will take a lot of time foreclosing so you can live in your home without paying on the mortgage, you may want to reconsider your strategy. The average foreclosure time nationwide is now up to 631 days. That is almost 21 months that you could theoretically live rent free. But knowing that there is the possibility that you will get a 1099 in the mail after your foreclosure should shift your financial analysis of this transaction.

For example, let’s say you bought a home for $350,000 at the height of the real estate boom. You got into an option ARM and never really paid down your principle at all. Because of a job loss or other legitimate reason, you may not be able to make your mortgage payments and decide to stick it to the lender who got you with that option ARM mortgage. You look at some of the other homes in the area and they are only selling for $200,000, so why would you continue to pay on a home that is worth 57.1% of what you paid for it? You don’t make your payments, get foreclosed on, and then move into a rental after you are evicted.

Fast forward to the new year and you are going through your mail and you notice an official looking document from your previous lender. You open it and there is a 1099 with $150,000 in income because the bank was only able to sell your home for $200,000. Depending on your tax bracket, you may owe up to 35.0% in income taxes on that $150,000. That means you would owe $52,500 in taxes. Really? Check my math. That would be $2,500 in taxes for each month you lived in the home.

Still sound like a good option? It can happen to you if the Mortgage Forgiveness Debt Relied Act is not extended beyond 2012. My advice is if you cannot afford the payments on your home, work with your lender on a loan modification. If you cannot get them to complete that process, get your home either sold using a short sale or consider a Deed in Lieu of Foreclosure. Both will still hurt your credit scores,  but I would suggest that if you want to avoid the taxes if the Act is not extended, then you will want to sell your home sooner than later.

If the Act is not extended and you are a first time home buyer, there will be some killer deals on homes during the 4th Quarter of 2012.

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Buy a Home in Utah
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