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In 2007, Congress enacted the Mortgage Debt Forgiveness Act to help homeowners affected by the housing crisis. This law remained in effect until the end of 2013. Though some in Congress have tried to extend the law, the prospects of this happening with a divided government during an election year remain unclear.
If you are a homeowner that went through a short sale or foreclosure resulting in a debt cancellation last year, the good news is that you should still be covered under the Mortgage Debt Forgiveness Act. In general, if the forgiven debt was on your principal residence and the amount is under $1 million for an individual and $2 million for a married couple filing jointly, the debtor does not have to pay income taxes on the amount forgiven.
What about homeowners that did not make the cut off: If the Mortgage Debt Forgiveness Act is not extended by Congress, it could leave many troubled homeowners in a bind. In many cases, it is just a matter of poor timing. For example, the short sale did not close until January 2014, or the foreclosure proceeding did not finalize until sometime in the New Year.
If you are one of those homeowners that missed the boat on benefiting from this Act, there may still be a way to avoid paying taxes on the cancelled debt from your home mortgage without having to file for bankruptcy; the insolvency exclusion.
What is Insolvency: Insolvency occurs when your financial liabilities exceed the fair market value of your financial assets. This condition is quite common with homeowners that are underwater with their home mortgages. For example, if you purchased your house in the peak of the market back in 2005 for $300,000, it is only worth $175,000 today, and your mortgage balance is $250,000, you may be considered insolvent.
Continuing with this example, if you sold your home this year on a short sale for $175,000 and had $75,000 of mortgage debt forgiven, you may be exempt from taxation for most (or all) of that amount, depending on what other assets you own and the amount by which you are insolvent.
How do I qualify for the insolvency exclusion: Many other factors go into determining which debts may be eligible for tax exclusion through insolvency. If you believe you may be eligible for this exclusion, before considering bankruptcy, speak with a professional accountant to discuss your particular circumstance and the options you have available to you. It may be that even without the Mortgage Debt Forgiveness Act, you can still avoid paying taxes on debt forgiven through a foreclosure or short sale.
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