The MLG Blog


Forgiveness of debt and home foreclosures

January 06, 2010

Many clients are concerned about the income tax consequences of haveing debt forgiven. They have heard through friends or relatives that if debt is forgiven they will receive a 1099 from the loan company, and that the forgiven debt will be deemed taxable income by the IRS. While this may be technically true there are exceptions that most people can utilize to avoid having to pay income tax on debt that has been forgiven.

Lets take a look at how the rules are applied to foreclosures and home loans, using an example of a home with 2 mortgages.

If it was a straight up foreclosure by the 1st mortgage company and the 2nd mortgage company didn’t get it’s loan paid off through the foreclosure the debt wasn’t forgiven on the 2nd mortgage.

In most foreclosures with 2 mortgages the second mortgage is totally unsecured and receives nothing through the foreclosure. An example might make this more clear.

Let’s say the house is worth $100,000. The first mortgage is fore $120,000 and the second mortgage is for $15,000. In this situation the first mortgages forecloses, at the sheriff’s sale the first mortgage will bid the amount they are owed or the actual value of the property, whichever is less. In this case they would bid $100,000. If no one outbids them the first mortgage company owns the house.

Since the first mortgage company technically bought the house for $100,000, but they were owed $120,000 the homeowner has had $20,000 of that first mortgage forgiven. The IRS considers any forgiveness of debt as the same as income and must be reported and taxed as income. However, the Mortgage Debt relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt or forgiveness of debt in connection with a foreclosure.

So in the example above the former homeowner would not be taxed on the $20,000 worth of debt forgiven through the foreclosure. However, the second mortgage is altogether different. The second mortgage company did not receive anything in the foreclosure and has not forgiven or discharged the debt. Usually the 2nd mortgage company will sue the former homeowner for the amount of the second mortgage under a breach of contract. If the former homeowner fails to defend or answer the lawsuit the second mortgage company will receive a default judgment and will begin collecting on that judgment.

Second Mortgages are often times what forces people in to bankruptcy, namely to get rid of the debt from a second mortgage.

More information can be found at the irs website on this topic at http://www.irs.gov/individuals/article/0,,id=179414,00.html

If you have questions about bankruptcy in Minnesota or debt and foreclosures please feel free to contact me at .(JavaScript must be enabled to view this email address).

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