Cancelled Mortgage Debt - Bulk Sales Addendum

This month we offer an informative article on the tax consequences of cancelled mortgage debt and an update from the NJAR regarding the Bulk Sales Act.

A TAX TEXT ON CANCELLED MORTGAGE DEBT

By Kenneth R. Harney

With hundreds of thousands of homeowners having negotiated loan modifications or short sales or been foreclosed upon during the past year, the Internal Revenue Service has issued fresh guidance on how to handle canceled mortgage debt in the upcoming tax season.

It’s a huge issue, widely misunderstood by consumers, and involves potentially billions of dollars of tax liability.

When most debts are canceled by a creditor, such as unpaid balances on student loans or credit cards, the forgiven amounts are treated as ordinary, taxable income by the Internal Revenue Code. But under a special exemption adopted by Congress covering distressed home mortgages, many owners can escape the ultimate double-whammy: Getting kicked while you’re down, hit with extra taxes because your mortgage went seriously delinquent or you lost your house.

In its latest guidance, the IRS focuses on several key points that owners – and former owners – need to know. Tops on the list: Just because a lender wrote off a portion of your mortgage debt, this doesn’t mean you automatically qualify for special tax treatment. To the contrary, there are essential tests you need to pass to qualify: The debt your lender canceled must have been used by you “to buy, build or substantially improve your principal residence.”

There’s a lot packed into these words, so it’s important to parse them carefully. Start with the house itself. It can’t be your second home, an investment condo, a weekend retreat or a seasonal home you occupy for less than half the year. It can only be your main residence, and fully documentable as such.

Next, the unpaid mortgage balance your lender canceled as part of a modification, short sale or foreclosure cannot have been used for non-qualifying purposes, i.e., for something other than acquiring or constructing the house or making capital improvements to it. Refinanced mortgage debt used for kids’ tuitions, vacation, buying cars or paying off credit card bills won’t make the grade.

The IRS offers a hypothetical example of how borrowers can mess up their chances for tax relief. A taxpayer took out a first mortgage of $800,000 when he purchased his home years ago. Thanks to strong appreciation in property values, the house was soon worth $1 million and the owner refinanced the mortgage to $850,000. The loan balance at the time of the refi was down to $740,000, and the owner used the $110,000 in cash-out proceeds to buy a new car and pay off credit card debts.

Bad move. A year or two later – presumably well into the recession and housing bust – the home value had plunged to between $700,000 and $750,000. The owner then convinced his bank to allow a short sale for $735,000 and to cancel the remaining $115,000 of unpaid debt.

Does the owner get tax relief on the full $115,000 under Congress’ special exemption? No way, according to the IRS. He only escapes income taxes on just $5,000 of the $115,000 because he spent the other $110,000 on a car and credit card balances – neither of which counts as “qualified principal residence” debt.

Greg Rosica, a tax partner with accounting giant Ernst & Young, says misunderstandings of the rules about mortgage debt forgiveness are “commonplace.” People often don’t know that “the equity line [money] you used for vacations” and other purposes “just will not qualify” under IRS rules. Taxpayers who walk away from their houses may be liable for taxes, said Rosica in an interview, if at some point the property “no longer was their primary residence” – say they rented it out for the period between their last payment and the foreclosure – effectively converting the house into rental property, not their principal home.

The IRS highlighted some other key points in its guidance:

--Mortgage cancellation relief is capped at $2 million for singles and married taxpayers, $1 million for married owners filing separately.
--Anyone who’s had mortgage debt cancellation as part of a loan modification or foreclosure should go to IRS.gov and download Form 982 and IRS Publication 4681 for additional filing details. Alternatively they can call 800-TAX-FORM to request copies. Lenders who write off unpaid mortgage balances typically provide borrowers with a year-end IRS form 1099-C cancellation of debt statement, including the amount of the loan forgiven and the fair market value of the property.

If you’ve had mortgage debt canceled but have never received a 1099-C from your lender, get in touch and request it if you want to avoid federal tax hassles.

Ken Harney is a real estate columnist with the Washington Post.

NEW BULK SALES ADDENDUM FOR CONTRACTS OF SALE

The NJAR® Risk Management Committee has developed a new Bulk Sales Addendum for Contract of Sales, which makes the buyers and sellers aware of the requirements. The New Jersey Bulk Sales Law, N.J.S.A. 54:50-38 applies to the sale of certain residential property. Under the law, the buyer may be liable for taxes owed by the seller if the law applies and the buyer does not file the Notification of Sale, Transfer o Assignment in Bulk (Form C-9600) with the Division of Taxation. NJAR®’s legal counsel recommends that all buyers file a Notification of Sale, Transfer or Assignment in Bulk (Form C-9600) with the Division of Taxation, whether it is residential or commercial transaction.

The NJAR® Bulk Sales Addendum to the NJAR® Real Estate Contract, Form #118 is available through the NJAR®online forms or our office by contacting Lori Sacalis at lsacalis@barpostlaw.com.

NJAR® is currently pursuing a legislative and regulatory fix for the Bulk Sales Act. For more information on Bulk Sales, please visit the NJAR® website.

-Dan Posternock

***The information included in this newsletter is not, nor is it intended to be, legal advice. You should consult an attorney for advice regarding your individual situation. We invite you to contact us and welcome your calls, letters and electronic mail. Contacting us does not create an attorney-client relationship. Please do not send any confidential information to us until such time as an attorney-client relationship has been established.