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Passing the test on canceled mortgage debt has tax rewards

March 24, 2011

Passing the test on canceled mortgage debt has tax rewards
Homeowners who went through loan modifications, short sales and foreclosures can avoid big tax bills if they qualify for a special exemption adopted by Congress.
March 13, 2011|By Kenneth R. Harney, Reporting from Washington
With hundreds of thousands of homeowners having negotiated loan modifications or short sales or been foreclosed upon during the past year, the Internal Revenue Service has issued fresh guidance on how to handle canceled mortgage debt in the upcoming tax season.

It’s a huge issue, widely misunderstood by consumers and involves potentially billions of dollars of tax liability.

Usually, when a creditor cancels debts, such as unpaid balances on student loans or credit cards, the forgiven amounts are treated as ordinary, taxable income by the Internal Revenue Code. But under a special exemption adopted by Congress covering distressed home mortgages, many owners can escape the ultimate double whammy: getting hit with extra taxes because your mortgage went seriously delinquent or you lost your house.

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In its latest guidance, the IRS focuses on several key points that owners — and former owners — need to know. Tops on the list: If a lender wrote off a portion of your mortgage debt, you don’t automatically qualify for special tax treatment. To the contrary, there are essential tests you need to pass to qualify: The debt your lender canceled must have been used by you “to buy, build or substantially improve your principal residence.”

There’s a lot packed into these words, so it’s important to parse them carefully. Start with the house itself. It can’t be your second home, an investment condo, a weekend retreat or a seasonal home you occupy for less than half the year. It can only be your main residence, and you need documents to prove it.

Next, the unpaid mortgage balance your lender canceled as part of a modification, short sale or foreclosure cannot have been used for something other than acquiring or constructing the house or making capital improvements to it. Refinanced mortgage debt used for tuition, vacations, buying cars or paying off credit card bills won’t make the grade.

The IRS offers a hypothetical example of how borrowers can mess up their chances for tax relief. A taxpayer took out a first mortgage of $800,000 when he bought his home years ago. Thanks to strong appreciation, the house was soon worth $1 million and the owner refinanced the mortgage to $850,000. The loan balance at the time of the refi was down to $740,000, and the owner used the $110,000 in cash-out proceeds to buy a new car and pay off credit card debts.

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From → Homeowners, Sellers, Taxes

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