PERSONAL FINANCE - A tricky tax can haunt debtor after foreclosure - President Bush proposes a temporary exemption. Here's a Q&A on how that might affect homeowners in distress.
In a package of proposals aimed at easing foreclosure worries for homeowners having trouble making their mortgage payments, President Bush called last week on Congress to temporarily make some borrowers exempt from a little-known tax that kicks debtors when they're down.
The provision, which assesses income tax on canceled or "forgiven" debts, can be triggered when a lender forecloses on a home or agrees to accept the proceeds of a property sale for less than the balance on the loan.
What is this tax, who is affected and what has Bush proposed? Here are some answers:
How can I possibly owe tax when I'm making no profit and losing all the equity in my home?
When you took out your mortgage, the lender gave you money, but you weren't taxed on it because an offsetting obligation -- your debt -- was created at the same time. If part of that obligation is eliminated before you pay it off, the unpaid amount that is wiped away is considered "cancellation of debt" income.
In the case of a foreclosure, the phantom income would equal the difference between the loan balance and the fair market value of the property at the time of foreclosure. For example, if you have $500,000 outstanding on your mortgage, but your house is worth only $450,000, the Internal Revenue Service will expect you to pay tax on the $50,000 difference if the bank forecloses.
Or instead of foreclosing, the bank might let you do a "short sale" for $450,000 and accept the proceeds as payment in full for the loan. A short sale can be preferable to a foreclosure because it's not quite as damaging to the homeowner's credit rating, but cancellation-of-debt income is still created.
In such cases, at least under current law, be prepared to receive IRS Form 1099 from the lender in January after the sale saying you received income equal to the portion of your mortgage that you didn't pay off, said Warren Hannagin, a certified public accountant at Glenn M. Gelman & Associates in Santa Ana.
Is the tax assessed at ordinary income tax rates?
Yes. So if you're in the 25% tax bracket, the details in the example above would boost your federal tax bill by at least $12,500. The extra tax would be more than that if the phantom income caused you to jump a tax bracket or two.
What did the president propose?
