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Until this year, there were definite tax consequences from escaping foreclosure through a short sale. Avoiding foreclosure has always been the best thing to do since it prevents a black mark on your credit report that might keep you from being approved for future loans. Most financial experts will tell you that even today, keeping a foreclosure off your credit report is more important than any added tax liability.
First, consider the credit problems
Whether you are foreclosed or choose an option such as a short sale or a deed-in-lieu of foreclosure, you will have to deal with the tax man. And most real estate professionals will advise you that a short sale is your best option if preserving your credit is important. There are a number of potentially-costly consequences of foreclosure, deed-in-lieu of foreclosure and a short sale. Most of these are the impact on a debtor’s credit rating. The first two, foreclosure and deed-in-lieu, have about the same impact—reducing your FICO score by 200 points or more. With a short sale, this reduction is more in the order of 100 points. You can also expect it to be impossible to get a new loan for 36 months or more with the first two, and around18 months with a short sale. This means that you will be able to recover from the credit impact much faster with a short sale. Nevertheless, there will be credit consequences no matter which solution you select.
Mortgage Forgiveness Debt Relief Act of 2007
The new Mortgage Forgiveness Debt Relief Act of 2007 all but eliminates the extra financial ‘hit’ a debtor would take due to tax liabilities. It was first introduced in the House in September, 2007 and finally signed into law by President Bush on December 20th, 2007. Now, the act is law and is termed Public Law No. 110-142.
Prior to this year, a debtor would suffer the loss of his home, negative impact to his credit rating and additional debt arising from federal tax laws that made the difference between what the home sold for and what he owed on his mortgage, taxable as income. The only escape from this new financial liability was to file bankruptcy which, regrettably, makes one’s credit terminally ill.
Public Law No, 110-142 (H.R. 3648) amends the Internal Revenue Code of 1986 to exclude discharges of indebtedness on principal residences from gross income and for other purposes. It does not, however, apply to homes purchased for investment and subsequently rented out. It only applies to homes where the owner has been in residence.
There are some limitations under the new act
The new law also reduces the income tax breaks on most gains from the sales of non-primary residences based upon a formula that considers the amount of time that the taxpayer actually lived in the property during the five years preceding the sale. And it limits the excludable amount of the indebtedness to $2-million and forbids the inclusion of indebtedness arising from services performed for the lender. There are other benefits and penalties as well. Perhaps most important, however, the new law keeps insolvent homeowners form taking an additional financial beating on a 1099 IRS gift of their short sale or foreclosure which only bankruptcy could do until this year.
Full details on Public Law No. 110-142 (H.R. 3648) can be had by going to: http://www.govtrack.us/congress/bill.xpd?tab=summary.
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