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Underwater? Will you be swimming with the sharks at tax time? p2

Most of us watched the story of the "fiscal cliff" unfold almost two years ago, and many of us are still confused about what exactly happened. Briefly, it looked like this: A number of federal tax cuts were set to expire at the end of 2012 at the very same time across-the-board spending cuts were going into effect. After much wrangling, Congress and President Barack Obama agreed on a package of bills that would soften the blow to the economy and, they hoped, to individual taxpayers.

Some of the tax breaks that were to expire were extended one more year, to the end of 2013. Among those was the Mortgage Forgiveness Debt Relief Act of 2007, a law enacted during the recession and the foreclosure crisis that suspended the rule that any mortgage debt that was discharged, whether through foreclosure or short sale or refinancing, counted as taxable income.

Perhaps an example is in order: A homeowner is underwater on his mortgage -- he owes more than the house is worth -- and can no longer afford to make payments. The homeowner and his lender agree that the home will be put on the market for an asking price closer to current market value. Like this: H owes $100,000 on his home, but the home's value has declined during the recession to just $75,000. H and his bank agree to sell the home in a short sale -- a buyer pays the $75,000, the market value, and the bank simply forgives the additional $25,000.

Generally, that $25,000 would then become taxable income for H. He has, essentially, earned $25,000 on his investment. While the "earnings" aren't cold, hard cash, they are an economic benefit that the IRS sees as taxable income.

So the Debt Relief Act suspended the rule. We'll explain more in our next post.

Source:, "Short sale can have grave tax implications," Ilyce R. Glink, Nov. 16, 2014

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