Dubiln Packard

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Do I Have To Pay Income Tax After A Principal Reduction?

pay tax after a principal reductionPrincipal 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.

IRS Publication 4681 provides all of the details.

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.

 

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Do I Have To Pay Tax After A Short Sale?

do i have to pay tax after a short saleGreat! You did a short sale and now your mortgage lender sent you a 1099C to pay income tax on the amount of the loan that was not paid at the sale.  What? Do you have to pay tax after a short sale?

Answer: maybe.

The IRS treats forgiven or cancelled debts as income.  Under IRS rules, the lender is required to notify the IRS and to send you a form 1099C which may obligate you the pay income tax on the forgiven amount when you prepare your taxes for the year of the short sale.  Let’s say you had a home mortgage loan where  you owed $350,000 and the lender approved a short sale for $250,000.  In approving the sale, the lender is also agreeing to take $250,000 (less expenses) as full payment on the loan.  That means $100,000 of the loan is forgiven.  The IRS looks at this forgiveness as income and wants you to pay tax on it.

There Are Exceptions That May Apply To You.

Waiver By Congress. Up until December 2014, Congress provided a waiver of the tax given the high number of home owners that were losing their homes after the financial crisis of 2008 but that law hasn’t been renewed at this point.  You may want to check to see if Congress has renewed the waiver but at this point, it does not appear likely.

IRS Rules.  You may need the help of your tax preparer or accountant but here’s what the IRS has to say about forgiven or cancelled debts.  In IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments, the IRS explains the federal tax treatment of canceled debts in certain situations. In short, if you are Insolvent in the eyes of the IRS, you do not have to pay the tax.

Insolvency. If you are insolvent according to the IRS just before the debt was cancelled, this exception may apply to you.

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.

A special note if you have retirement savings: 401(k)s and IRAs count toward your assets.  Please note that in the above guideline, the IRS does not exclude retirement savings from your assets.  This may prevent some people from qualifying for this exception. If you do have retirement savings, it is important to know that that retirement savings is exempt from assets in bankruptcy so in this case, bankruptcy may be a better option for you in that it saves you the tax and preserves your retirement savings.

Bankruptcy.  If you file for bankruptcy, whether chapter 7 or chapter 13, the bankruptcy exception may apply to you.

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.

There may be other exceptions that apply to you but these are the two that apply to most people.

This IRS rule also applies in the rare event the amount you owe is reduced as part of a loan modification or if the lender simply cancels your loan as sometimes happens with second mortgage loans when the lender realizes the value of the homes has dropped significantly.  You can read more about that here.