If you’re one of many homeowners who paid top dollar for your home and are still waiting for the price to recover, don't forget about an important tax break. 

Mortgage debt that a lender forgives- say, by restructuring your loan or through foreclosure- is not taxable as “income” on your federal tax return While you still have to report it, this is a huge savings and it’s (still) here for only a limited time.  

Say uou bought a home back in 2006 for $400,000 and you put down $60,000 and took out a mortgage for $340,000. Now the home is worth around $330,000 and you are no longer able to make the monthly payments because your spouse has been unemployed for three years. To avoid the expense and delay of foreclosure, you and your lender agree to a “short sale” where you sell your home for less than the outstanding debt attached to it.

While a short sale releases you from your mortgage, whether your lender can still try to collect the balance depends upon where you live. According Mark Luscombe, principal federal tax analyst with CCH, “some states say that the most the mortgage lender can go after you for is amount the house is sold for. If this doesn’t cover the total balance, the lender is out of the money. They can’t pressure the homeowner for the balance.” However, this is the exception rather than the rule.(1) 

Assume that in the above example, you end up with $320,000 after real estate commissions and other costs. You turn this over to your lender who has agreed to cancel the nearly $20,000 still owing on your loan. If we were talking about a boat or a credit card account, you would have to report the forgiven $20,000 as “income” when you file your taxes. If you’re in the 25% bracket, you’d owe Uncle Sam $5,000.

However, in response to the collapse of the residential real estate market several years ago, Congress passed the Mortgage Forgiveness Debt Relief Act. This allowed homeowners saddled with underwater mortgages to exclude home-related forgiven debt from their income when filing their taxes--but only if the debt was cancelled from 2007 through 2012.

If you received home-related debt forgiveness last year, you should have received a Form 1099-C “Cancellation of Debt” statement, from your lender. You’ll need this information to file Form 982, “Reduction of Tax Attributes Due to Discharge or Indebtedness,” with your federal tax return.

Keep in mind that your lender also sends the IRS a copy of Form 1099-C.  So, if you don’t attach Form 982 to your return, “the IRS will assume the forgiven debt is taxable and you’ll get a letter assessing a tax and penalty,” says Luscombe.

The good news for homeowners who couldn’t complete the restructuring of their loan or the sale of their home by the end of last year is that they have more time. As part of the temporary legislation to avert the “fiscal cliff,” this tax break has been extended through Dec. 31, 2013.  Any kind of home-related debt - a mortgage, home equity line of credit, etc.- qualifies provided it meets the following requirements:  

1. You must have used the money to buy, build or improve your primary residence. Second homes don’t get the tax break.  

2. A refinanced or a second mortgage qualifies if you used the money to improve your primary home, according to Luscombe.

3. The maximum you can exclude from income is $2 million. If you file “married/separate” the limit is $1 million.

Just to clarify, a home equity loan that you used to pay for your kid’s junior year at State U. doesn’t qualify.  Neither does a loan that was taken out to buy or improve a rental property or vacation home. 

1. Experts in this area strongly advise you get legal help before entering into a short sale.  Only a handful of states- such as California- prohibit a lender from going after a borrower who still owes money on a mortgage.  It’s critical that your short sale agreement be properly worded.  In addition, keep in mind that in the eyes of a future creditor, there is little difference between a short sale and foreclosure- the former is a simply the voluntary sale of your property, while the latter is a forced sale.  Both severely damage your credit rating.

Ms. Buckner is a Retirement and Financial Planning Specialist and an instructor in Franklin Templeton Investments' global Academy. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

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