Avoiding Paying Tax on Short Sale and Foreclosure

Insolvency can leave a homeowner with little hope and few options of ever meeting their financial obligations to their lenders. Given the ongoing foreclosure crisis in North Jersey, it may be appropriate to mention two avenues in which lenders and homeowners can deal with the populaces increasing inability to pay off their debts.

Two methods of dealing with this issue require the homeowner to give up their property either by way of:

  1. short sale
  2. foreclosure

As mentioned before a foreclosure occurs when a debtor fails to make their regular payments and the creditor attempts to foreclose on the debtors right to redeem the property, forcing the property to be sold to the highest bidder. When dealing with a short sale, the debtor’s property is sold below the value of the liens on the property, and the creditor takes the amount it was sold for while agreeing to release the lien on the property. In both scenarios the creditor can agree to forgive the rest of any portion of the debt no fully satisfied by the sales.  While beneficial to the debtor, these sales could lead to unwanted tax consequences for the debtor.

Options for Avoiding Tax Include…

With the expiration of the Mortgage Debt Relief Act of 2007, which excluded the amount of the forgiven debt from taxable income, debtors lost a simple avenue to avoiding tax liability resulting from these sales. However this was only one lost avenue, other avenues still remain. One method of avoiding tax liability for these sales requires the debtor to be deemed insolvent, meaning if the amount of his debts exceeds the value of his assets then the debtor will not have tax liability. Bankruptcy is also another very strong option for a debtor who is facing a short sale or a foreclosure. If a debtor files for bankruptcy all of his personal liability is discharged at the completion of the bankruptcy. Provided that the bankruptcy is filed before the home is sold the Internal Revenue Service will not attempt to collect taxes on the forgiven debt. What all of this essentially means is that with the expiration of the Mortgage Debt Relief Act, debtors have lost a useful tool in avoiding tax liability for forgiven debt resulting from short ales and foreclosures. However debtors still remain free to exercise other options to avoid this liability.

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