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How meaningful is debt relief if you have to pay tax on it?

Before 2007, financially distressed homeowners who had received debt relief as part of principal reductions, short sales or foreclosures had to pay taxes on those forgiven amounts to the Internal Revenue Service. The lender also had to report forgiven amounts to the IRS.

However, in 2007, Congress enacted the Mortgage Forgiveness Debt Relief Act to provide a special tax exemption to struggling homeowners. If the bank forgave the debt because the home’s value dropped or the borrower’s financial condition had declined, then couples filing jointly were exempted from paying taxes on the forgiven amount up to $2 million.

Originally, the exemption was set to expire at the end of 2010. However, because of the 2008 housing market crash and economic recession, Congress extended the tax break until the end of 2012. Consequently, distressed homeowners may have to again pay taxes on the amount of debt relief they have or will receive beginning in 2013.

Proponents of the tax exemption say that it is particularly important because the country’s five largest banks have started providing principal reductions and other debt relief as part of a $25 billion national mortgage settlement. Approximately 140,000 homeowners received an average of $77,000 in debt relief in the second quarter of this year. Without the exemption, a middle-class household would owe taxes of 25 percent of that relief, or about $19,000.

Some lawmakers have proposed bills to extend the exemption, but it is questionable if Congress will vote on them before the November election. Homeowners who receive principal reductions this year still can still claim the exemption on their 2012 tax returns. However, much of the debt relief from the national mortgage settlement is likely to come after this year.

Source: Press Of Atlantic City, “Mortgage debt relief may become costly in ’13,” Jim Puzzanghera, Sept. 9, 2012

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