Principal reduction is the Holy Grail of loan modifications but they are just so hard to get. If you are lucky enough to have principal reduction included as part of a loan modification, you may have to pay income tax on the amount of the principal reduction. Here’s Why….
Do You Have To Pay Income Tax After A Principal Reduction?
Just like a homeowner has to pay income tax on the amount of debt that was forgiven after a short sale, the same applies when the lender reduces the amount of the debt owed through a loan modification that includes a principal reduction.
The IRS treats cancelled or forgiven debt as income. There are some exceptions. For example: if you are insolvent or if you file for bankruptcy. These are the two most common exceptions that apply to people in foreclosure. You may need the assistance of your tax preparer or accountant but take a look at IRS Publication 4681 which provides guidance on canceled debts.
Principal Reduction is Cancelled Debt.
In Publication 4681, the IRS clearly considers principal reduction as cancelled debt. If you were given a loan that has a principal balance of say $400,000 and the lender agrees to modify your loan to a balance of $300,000, the lender cancelled $100,000 worth of debt and you may owe tax on that amount.
There may be an exception that applies to you.
Insolvency. In Publication 4681, the IRS provides: Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the fair market value (FMV) of all of your assets immediately before the cancellation. For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of your retirement account). Liabilities include: The entire amount of recourse debts, the amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt, and, the amount of nonrecourse debt in excess of the FMV of the property subject to the nonrecourse debt to the extent nonrecourse debt in excess of the FMV of the property subject to the debt is forgiven.
Bankruptcy. In Publication 4681, the IRS provides: Debt canceled in a title 11 bankruptcy case is not included in your income. A title 11 bank- ruptcy case is a case under title 11 of the United States Code (including all chapters in title 11 such as chapters 7, 11, and 13), but only if the debtor is under the jurisdiction of the court and the cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court.
Knowing where you stand with the IRS and whether or not you are going to have to pay income tax after a principal reduction is an important part of understanding your options when in foreclosure or trying to obtain a mortgage loan modification.