Beware of the IRS If Your Home Is Underwater

It is not unusual for a home to be worth less than what the owner owes on the mortgage. This is commonly referred to being “underwater”. As long as the owner pays the mortgage on time, eventually the mortgage will be paid down and the house may appreciate in value. However, when the owner becomes delinquent on the mortgage, severe consequences may arise with the IRS.

Say your home is foreclosed and you don’t care because you decide that an underwater house is not worth saving. If the house is sold at the sheriffs sale for less than what you owe on the mortgage, your lender can decide to release you from the deficit on the loan payoff. But then your lender will issue a 1099 to you, documenting its forgiveness of that debt to the IRS. The IRS considers that to be taxable income to you. You will have to report that amount on your tax return and pay tax on it.

The same result can occur on a short sale, when your lender agrees to accept less than the full amount. Also, a loan modification involving the forgiveness of debt can also result in the IRS imputing income to you.

For many years, Federal legislation exempted owner occupying homeowners from this harsh result. However, that law has expired and unsuspecting homeowners need to consider another strategy.

In order to avoid the imputation of income by the IRS on an underwater house, your best bet is to file a Chapter 7 bankruptcy petition to discharge the entire mortgage debt. As long as the bankruptcy is filed before the event creating the imputation of income, such as a sheriffs sale, then you will not have any taxable income based upon debt forgiveness. Of course, you will need to qualify as a Chapter 7 debtor, including meeting the income guidelines. If you do not qualify for Chapter 7, you may be able to file a Chapter 13 bankruptcy, but that would usually involve at least partial repayment of the debt.

Please call us today for further information on your options.

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Charles D. Whelan III has been committed to excellence for over 30 years. With offices located centrally in New Jersey, he is able to provide businesses and individuals with excellent legal services.

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