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Currently, any debt forgiven by a lender in a short sale, loan modification, or foreclosure is exempt from federal taxation. However, that exemption is scheduled to expire Jan. 1, 2013.
- Borrowers will have to count mortgage relief from lenders as income on their federal tax returns, if the exemption is allowed to expire. That means, for example, a borrower would have to pay taxes on a $100,000 reduction in principal owed on a loan, or a $20,000 write-off in the amount owed after a short sale.
- An extension of the tax exemption – established under the Mortgage Forgiveness Debt Relief Act of 2007 – is a strong possibility. But given that Congress will have to grapple with serious fiscal issues after the November elections, there is no guarantee the exemption will emerge from those negotiations intact.
- The Debt Relief Act exemption applies only to canceled mortgage debt used to buy, build, or improve a primary residence, not a second home. The maximum exemption is $2 million.
- Reinstating the tax would undercut the the effect of the National Mortgage Settlement reached earlier this year in the federal government’s investigation into banks’ mishandling of foreclosure documents.
- Under the terms of the settlement, five of the biggest mortgage lenders must put some $17 billion toward debt relief that enables borrowers to stay in their homes. Smaller portions are reserved for short sales and refinancing.