Income Tax Hit Bites Some Underwater Homeowners

The Wall Street Journal reports:

• [Homeowner] Maxine McDaniel has a message for Americans considering walking away from an unaffordable mortgage: Beware of taxes. Though not every homeowner who's underwater on a mortgage need worry, many are finding that a foreclosure or other form of housing loss can lead to a big tax obligation.

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• In many of those instances, say Treasury officials, homeowners used mortgage money to fund everything from tuition and medical bills to vacations and cars and even the down payment on a second home or investment property. That debt, however, isn't eligible for exemption. Sometimes the tax bills are so high that people can't afford to pay. In such a situation, the IRS will allow taxpayers to apply for an installment-payment plan.

• Some homeowners can avoid the taxes completely if they can prove insolvency, in which the total value of debt exceeds total assets. But even that could leave some owing taxes. IRS rules stipulate that a taxpayer can escape taxes up to the extent of insolvency, meaning that if one's liabilities are $500,000 and assets are $300,000, the $200,000 difference is the extent of the insolvency. But if the person has $250,000 in debt canceled, then $50,000 is taxable income.(1)

For more, see A Surprise Tax Hit on Foreclosures (For People Who Lose or Walk Away From Their Homes, A Big Tax Bill May Loom).

(1) The following information from the Internal Revenue Service may come in handy in determining how much income tax may be owed to the Feds, and more importantly, whether a homeowner can qualify for one of the law's exceptions from taxation (ie. exception for taxpayers for acquisition or home improvement debt forgiven on their principal residence if the balance of their loan was $2 million or less, insolvency exception, & bankruptcy exception are the three most common) that will allow him/her to dodge the tax either entirely, or at least partially:

• IRS Tax Tip 2010-44: Ten Facts about Mortgage Debt Forgiveness,
• IRS Publication 4681: Canceled Debts, Foreclosures, Reposessions and Abandonments,
• IRS Information Release IR-2008-17: Mortgage Workouts, Now Tax-Free for Many Homeowners; Claim Relief on Newly-Revised IRS Form,
• The Mortgage Forgiveness Debt Relief Act and Debt Cancellation,
• IRS Form 982: The amount of debt forgiven must be reported on this form and must be attached to your tax return.

Homeowners finding themselves owing Federal income tax and having no cash to pay it may want to check out one of the following two separate approaches the IRS offers for dealing with the delinquent taxes:

• IRS Offer-In-Compromise - see IRS Form 656, & IRS Form 656-B (46 pages of Instructions - 1.6 MB), & go here for more on IRS Offers-In-Compromise; and
• Payment Plans, Installment Agreements - see IRS Form 9465).