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Dear Tax Talk,
I lost my job last summer. Our income took a significant hit, as my new job pays about 70 percent less than
my old job. In addition to the loss of income, our house value has decreased $100,000 in the past 18 months.
We now owe $95,000 more than what our house is worth.
We fell several months behind on
our home loans. We have an 80 percent, five-year
ARM first mortgage and a 20 percent adjustable-rate
HELOC. Two weeks ago, we reworked our first mortgage.
The mortgage company lowered our interest rate/payment
and added the overdue amount to the end of the
loan.
We just received an offer from the HELOC mortgage company to settle our entire loan debt for a
fraction of what we owe. They are offering to let us settle the entire $62,000 loan for $5,000, "as full and
final satisfaction of your account."
Obviously this would help us out tremendously, especially due to the significant loss in value
of our home. Since settling the loan does not require a short sale or foreclosure, and allows us to stay in our
home, we do not know how this will affect our credit or taxes. We would like to know what the tax consequences
are if we settle the loan for much less than what we owe.
We have seven days to respond to the lender, and any information you can provide would be greatly
appreciated. Thank you!
-- Michael
Dear Michael,
Welcome to the American nightmare. While Congress and the president can't help you with the step-down on the job,
they did provide some relief when it comes to mortgage workouts.
When debt is incurred, it is not
considered income under the principle that it
will be repaid. When debt is not repaid and forgiven
by a lender, the taxpayer is considered enriched
and, as a result, realizes income.
In the current real estate and mortgage climate, this is not the case. Personal residences have
declined in value and taxpayers are not allowed to deduct these losses. But under the unpaid debt theory, these
taxpayers have realized income.
In passing the Mortgage Forgiveness Debt Relief Act, Congress and the president have acted to
eliminate the income tax aspect of a debt renegotiation in limited circumstances.
Under the new law, if a debt that was used to buy, build or substantially improve the taxpayer's
primary residence is forgiven, the forgiveness will not be considered income. Instead, the amount forgiven reduces
the taxpayer's cost in the home.
If the 80/20 split was used in full
to buy the home, you won't have any gain or income
resulting from the $57,000 reduction in the HELOC.
If you used the HELOC for any purpose other than
buying, building or improving the home, you could
gain from the debt restructuring.
However, other exceptions exist that may help you in avoiding income recognition, if this were to
be the case. I can't tell you what impact the renegotiation will have on your credit, but you can probably assume
it won't be positive.
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