When a mortgage company agrees to accepts a lesser amount than what is due on the mortgage, then the amount of savings can be taxed as if it were ordinary income. This is the concept of “imputed income.”
If a mortgagee forgives some or all of the balance owed on a mortgage, then the forgiven mortgage debt is taxable.
Thus, if a lender agrees to accept a payout of $100,000 on a mortgage, even though $150,000 may be owed, that $50,000 forgiven amount could be taxable as if it were regular income that the homeowner earned.
However, in 2007, Congress passed the Mortgage Forgiveness Debt Relief Act, which eliminated imputed income under most circumstances when mortgagees accepted a lesser amount. That was great news for homeowners during these past five years, enabling many hundreds of thousands of them across the country to do short sales or mortgage modifications in which the lender accepted a reduced pay-off as full satisfaction — and the homeowner had no income tax consequences.
Unfortunately, this tax break comes to an end the last day of this month, and absent any extension by Congress, consumers will be on the hook for paying income taxes on any mortgage principal reduction, beginning with mortgage reductions that occur on or after January 1, 2013.
Of course, if Congress gets their act together by preventing a fall off the fiscal cliff, this tax benefit may be extended another year, into 2014.
Incidentally, when a consumer just walks away from real estate by filing for bankruptcy, there are no tax consequences, and the consumer can discharge the full mortgage obligation without worrying about imputed income at all.
But if Congress doesn’t act soon, mortgagees will be obligated to file IRS 1099-C forms in 2013, showing the amount of canceled debt.