Question: We bought our home in a new Gilbert subdivision six years ago. Although there has been some appreciation lately, our home is worth only $260,000. We still owe $380,000 on the mortgage. After my husband lost his job last year, we finally had to stop making payments, and the foreclosure occurred this February. Our accountant now says that we could have income tax liability for the $120,000 difference between the amount of our mortgage ($380,000) and the value of our home ($260,000) at the time of the foreclosure. Many of our neighbors in our subdivision have lost their homes to foreclosure, or have done a short sale, and they never said that they had any tax liability. Is our accountant right?
Answer: Although the question is simple, the answer is not easy in Arizona. The general Internal Revenue Service rule is that any forgiveness of debt will be taxable income. In response to the housing disaster of the mid-2000’s, however, the Mortgage Forgiveness Tax Relief Act was enacted by Congress in 2007 to give relief to taxpayers who had debt forgiveness as a result of a foreclosure or as a result of a short sale. (In a short sale, the bank agrees to accept payment of less than the full amount of the mortgage when the home is sold.) Although the Mortgage Forgiveness Tax Act was extended several times, Congress refused to extend the act after Dec. 31, 2013. In other words, all of your neighbors in your Gilbert subdivision who either lost their home to foreclosure or did a short sale of their home before Dec. 31, 2013, had no tax liability for any debt forgiveness.
Your question, however, is: After Dec. 31, 2013, what is the tax liability of an Arizona tax payer for forgiveness of debt after a foreclosure or short sale? Although one IRS general rule is that any forgiveness of debt is taxable income, another general IRS rule is that there is no taxable income after forgiveness of non-recourse debt. (With non-recourse debt, the borrower has no personal liability and the lender’s only recourse after default on a loan is to foreclosure on the secured property such as a home). A mortgage loan used to purchase a home in Arizona is non-recourse debt. In other words, in Arizona, unlike most states, the home owner has no personal liability for a mortgage used to purchase a home. Therefore, the debt forgiveness to you of $120,000 should not be 2014 taxable income to you.