In light of the current economic crises plaguing our country, your home may be on the brink of foreclosure, or will be sold by way of a short sale. You may also have staggering credit card debt. Therefore, when entering into a property settlement agreement that involves debt forgiveness (i.e. foreclosure, short sale, and reduction in credit card debt) it is critical that you choose a matrimonial attorney that is aware of the tax consequences associated with debt forgiveness because the financial impact can be enormous.

Historically, debt that was forgiven or cancelled by a commercial lender must be included as income on your federal and state tax return and was taxable. For example, if the total amount of the mortgage debt immediately prior to the foreclosure was $220,000 and the fair market value of the property was $200,000, the amount of the debt forgiven, $20,000, was treated as taxable income. Unless of course the borrower qualified for an exception under the Federal Tax Code, i.e., bankruptcy, insolvency, certain farm debt, and non-recourse loans.

On December 20, 2007, the Mortgage Debt Relief Act of 2007 (hereinafter referred to as “the Act”) was enacted. Said Act provides financially strapped homeowners with some relief in connection with treating debt forgiveness as income. Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on a principal residence that occurred in 2007, 2008 or 2009. Moreover, there is no dollar limit if the principal balance of the loan was less than $2 million ($1 million if married filing separately for the tax year) at the time the loan was forgiven.

What the Act does not do is provide relief to all forgiven or cancelled debt. Its application is severely limited to a forgiven or cancelled debt used to buy, build or substantially improve a principal residence or to refinance debt used for those purposes.

  • There is no relief for any debt forgiveness for a vacation or investment home.
  • There is no relief for credit card debt reduction.
  • There is also no relief available for cash-out mortgages whether the cash take-out takes the form of a refinanced first mortgage, a second mortgage, a home equity line of credit or similar arrangement.

For example, if an individual takes out a home equity line in the amount of $50,000 to pay off credit card debt then sells his home, via a short sale, for $300,000 but owes $350,000 on the first mortgage and $50,000 on the equity line used to pay credit card debt, the borrower will be required to claim the $50,000 as income on his federal income tax return. Moreover, the borrower will most likely be required to claim the entire debt forgiven, $100,000, on his state income tax return because the Mortgage Debt Relief Act only applies to federal income tax.

Why is this significant? This is significant because your principal residence, that has a cash-out mortgage, may be on the brink of foreclosures, or may be sold by way of a short sale. Or, your vacation home and/or investment properties may be in foreclosure or sold by way of a short sale. If that is the case, either a portion or all of the debt forgiveness will be considered taxable income. You will receive a 1099C from the lender and you will have to claim the debt forgiveness on your federal and state income tax return. If you are not yet divorced, a joint federal and state income tax return can be filed and an agreement can be reached as to how the tax debt associated with the marital property will be apportioned. However, what happens if you are already divorced and foreclosure or a short sale of marital property was not contemplated in the property settlement agreement? How are you going to deal with the tax consequences of the debt forgiveness? The party who received the 1099 and is compelled to claim the debt forgiveness on his or her federal and state income tax return will want the ex-spouse to share in the tax consequences. Most likely, the party who did not receive the 1099 will refuse to share in the tax debt, especially if it was a hotly contested divorce. Thus, it is imperative that debt forgiveness associated with your principal residence, vacation home, investment property, credit card debt reduction etc. be addressed in your property settlement agreement. Even if you and your spouse are solvent when the property settlement agreement is drafted, in today’s economy it is not a far fetched scenario that an individual could lose their job, be unemployed for a significant period of time, and have their home or homes sit on the market for a year or more with no offers in sight. That is a recipe for foreclosure or a short sale. By simply including a clause in a property settlement that addresses how the tax consequences of debt forgiveness will be treated in the event of same will alleviate a litany of post judgment applications.

The family law attorneys here at Fox Rothschild, LLP are well versed on these issues and can effectively assist you through this difficult time in your life.