Tax Exemptions for Underwater Homeowners

America's mortgage industry is slowly recovering. But, according to real estate site Zillow, 16 million homeowners still owe more than their homes are worth. And, while taxes may not be top of mind for these underwater homeowners, there are some helpful advantages afforded to these borrowers via the Mortgage Forgiveness Debt Relief Act.

A Mortgage Forgiveness Debt Relief Act Briefing

Prior to the Mortgage Forgiveness Debt Relief Act, struggling homeowners were forced to pay taxes on forgiven debt. It may sound backwards — why should you have to pay taxes on money you lost? But the IRS viewed the forgiven debt as a gift.

For example, according to MarketWatch.com, a borrower who owed $200,000 in the 25% tax bracket who sold his home in a short sale for $150,000 would typically pay $12,500 in taxes. That's because that the IRS views the $50,000 break as taxable.

Previously, there really was no way around it. In fact, the only way one could avoid such a tax would be to declare bankruptcy or claim insolvency, stating that your debts outweighed your assets.

But thanks in part to the special federal tax break — the Mortgage Forgiveness Debt Relief Act — underwater homeowners can now avoid paying this extra tax. For example, that same borrower who owed $200,000 in the 25% tax bracket would pay no taxes for a $150,000 short sale. Notably, the bill allows the Internal Revenue Service to exclude up to $2 million in forgiven mortgage debt in buyer income statements.

Some Stipulations

It is important to note, however, that this tax break is not all inclusive. If you took cash out of your home during refinancing and used it towards paying for your child's education, family vacations, or home improvements, you will not be eligible for the Mortgage Forgiveness Debt Relief Act.

Additionally, not all local governments adhere to federal rulings. In fact, homeowners in certain states may still be forced to pay state income taxes on that forgiven debt.

So, What Do You Need to Qualify?

In order to qualify for the debt relief act and not be forced to report the cancelled debt, one must have:

• Forgiven debt on your principal residence
• Debt reduced or forgiven through mortgage restructuring, foreclosure, or short sale
• Up to $2 million of forgiven debt
• Only used forgiven or cancelled debt to buy, build or substantially improve his principal residence

Will I Receive Any Paperwork?

If you do choose to have your mortgage debt forgiven, you should receive a 1099-C, Cancellation of Debt from your lender. This statement will detail the amount of debt that was forgiven. It will also list the current market value of your home. You will need to reference these numbers when filing your taxes.

The information provided above is not intended to take the place of professional counsel. If you believe you qualify for tax exemptions under The Debt Relief Act, contact your tax advisor for more information and further eligibility requirements.