In the summer of 2007, Congress passed a historic legislation known as the Mortgage Forgiveness Debt Relief Act. This legislation was supposed to provide relief to those homeowners who were struggling to stay afloat or who were already underwater. The highlight of this legislation was that it allowed for tax exemption on short sales of homes. The legislation was justified in its intent as it seemed only logical that people who cannot afford to keep their homes must not be expected to pay huge tax returns.
Even though the provisions of the legislation were initially drafted to stay active for just one year, it was renewed every consecutive year.
- Understanding the Mortgage Forgiveness Debt Relief Act:
Consider the scenario where you have borrowed money from someone, now if in future the lender forgives the debt then according to the law this forgiven amount will be deemed as income and it will be taxed accordingly.
The Mortgage Forgiveness Debt Relief Act made provisions that safeguarded American citizens from being taxed on the forgiven debt. However, the Act applied to only those forgiven or cancelled debt that was used in connection with your principal residence. What it means is that if you have a forgiven debt that you have used to buy, build or improve your principal residence then according to the Act you will not be taxed on the forgiven amount.
- The problem we are facing today:
The legislation was supposed to end in 2009 but it was renewed twice. The reasons for reenactment of the Act were obvious, economy was on a downward slope and people needed help. The issue is that even today the economy has not shown any considerable improvement but the tax break has expired. There are a lot of people who are still struggling; imposing taxes on their forgiven amount will not make much of a sense.
It seems highly impractical and unreasonable for the federal government to tax someone on the money that they have not earned but this is the reality and if the legislation is not renewed soon then you will be taxed heavily on the forgiven amount.
Let’s consider a practical example, suppose that you owe $300,000 on your home mortgage but the maximum amount that can be raised through a foreclosure or short sale is only $250,000. Now if the lender agrees to forgive the remainder of the debt i.e. $50,000, then according to the law he will be required to report this forgiven amount to the IRS and you will taxed on this forgiven debt.
- Some are in favor of letting the legislation expire:
Many experts have argued that such tax exemptions hamper the economy it directly implies less revenue for the federal government. It has been argued that instead of renewing the Mortgage Forgiveness Debt Relief Act the government should popularize the alternative i.e. the new plan of insolvency exclusion. According to this new plan a citizen can escape from paying taxes on the forgiven debt if he/she can prove that his/her total liabilities exceed his/her total assets.