As the mortgage crisis settles in and banks, consumers and even the government try to figure out what they need to do to deal with it the phrase “debt forgiveness” is being used more and more often. I’ll leave it to someone else to work out who’s responsible for this mess and whether forgiveness is right or wrong. The problem this presents from a taxing perspective is that forgiveness could be considered income.
Think about it this way – Joe bought a house in 1997 for $200,000. In 2002 he had it appraised and found out that developments in his neighborhood including a new elementary school built just two blocks away had increased his property value to $225,000. The equity in his house covered all of his credit card debt so he gleefully cashed it in. In all the excitement he didn’t notice that in five years his then insanely low house payments would jump to a budget-crippling amount. So now, five years later, Joe’s in trouble. He’s paid hardly any of the principle and suddenly his payments are more than he can afford.
After months of collection efforts the bank finally decides to foreclose. The house only goes for $175,000 on the auction block leaving a difference of $50,000 on Joe’s mortgage. Rather than trying to make him pay the bank just writes off the debt and suddenly Joe owes $50,000 less than he did the day before. Although Joe will receive no tangible benefit from this, in the eyes of the government that $50,000 constitutes taxable income and poor Joe, already financially strapped, will have to cough up the money to pay taxes on the additional “income.” That is until recently.
The newly passed Tax Increase Prevention Act of 2007 allows that this “income” will no longer be counted as income when it comes to paying taxes. Even though the act will slow the beginning of the tax season somewhat while the IRS prepares forms to match it’s new provisions, it will apply to 2007 taxes. This will not only help out those that have faced foreclosure in the manner described above; it also applies to instances were the terms of the mortgage are renegotiated to the benefit of the debtor.
Even though most taxpayers who find themselves in such unfortunate circumstances often don’t, and usually can’t, weigh the tax consequences of their actions now they won’t be faced with such a nasty result as unexpected additional taxes.
Bryce Eddings is a freelance writer. If you have questions about any tax issue that requires professional assistance, contact
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