I receive a lot of questions on what happens if I do a loan modification or go into foreclosure and part of the principal is reduced.  Will I have to pay federal taxes for the difference between what my mortgage was and what the house sold for in foreclosure ?  For example, say a person has a mortgage of $500,000 and lets the house foreclose or does a short sale.   The bank sells the foreclosed home for $400,00 losing $100,000 of the principal. This would be considered ordinary income to the owner of the home which which did a short sale or let the house go into foreclosure.

According to the Wikipedia

“The Mortgage Forgiveness Debt Relief Act was introduced in Congress on September 25, 2007, and became law on December 20, 2007. This act offered relief to homeowners who would formerly owe taxes on forgiven mortgage debt after facing foreclosure. The act extends such relief for three years, applying to debts discharged in calendar year 2007 through 2009. (With the Emergency Economic Stabilization Act of 2008, this tax relief was extended another three years, covering debts discharged through calendar year 2012.)

Normally in US law when a lender decides to forgive all or a portion of a borrower’s debt and accept less, the forgiven amount is considered as income for the borrower and is liable to be taxed.

However, after the signing of the Mortgage Forgiveness Act, amendments have been made to remove such tax liability and allow the borrower and lender to work freely together to find a common solution that is beneficial to both parties. This protection is limited to primary residences — rental properties are ineligible for relief — so consultation with a tax adviser is necessary to ensure that a borrower qualifies.  The amount of forgiven mortgage debt allowed to be excluded from income tax is limited to $2 million per year.”

There are many tax consequences and twists in short sales and foreclosures so consult a tax attorney or a certified public account to protect yourself. In some cases, the bank can go after the home owner after foreclosure for the difference between what was owed on the mortgage and what the home sold for. I will discuss this in future articles.