What is Debt Forgiveness & Why Should You Care?

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There are millions who have already lost their property in foreclosure, surrendered it with a deed in lieu of foreclosure or done a short sale. A short sale means that a sale occurs for less than the mortgage, which creates some forgiveness of debt. Actually in all of these cases, there is most likely forgiveness of debt. Let me back up and explain what that means.

Let’s say you bought a property for $400,000, put $40,000 down and got a loan for $360,000 It’s now worth $200,000 and you lose the property. You actually owe the mortgage company the difference – $160,000. If you’ve lost the property in foreclosure, they may have the right to come after you for that difference. If you instead surrender the property with a deed in lieu of foreclosure, they can also come after you. However, if you have a loan modification specialist helping you, you will likely get an estoppal negotiated. That means that the bank can not come after you for that difference. Likewise if you do a short sale and sell the property for the same $200,000 with a mortgage of $360,000, the bank could come after you for the difference. Hopefully you’ve had an expert advising you and you get an estoppal for the difference.

I want to stop right here. I’ve had the opportunity to talk to some very knowledgable and “in the know” people about this very situation this past week. The consensus is that it is very likely that banks WILL come after the former owners in 2-3 years, after the owners have had a chance to get back on their feet. One of the questions that I was involved with is actually a legal one – how much time do they to come after someone. Looks like it might actually be 4 years. That’s a big window. The only solution is either bankruptcy or, the better answer, a negotiated estoppal action up front.

Now, let’s say they do NOT come after the former owners. In that case there has been a forgiveness of debt. That means that the lender has given you something. And that means it is taxable. By the way, this is also true if there is a loan modification that reduces the principal amount of the loan or if there is an adjustment to credit card balances. There is debt foregiveness and that is taxable.

There are two ways to avoid the tax on this debt forgiveness: (1) declare bankruptcy or (2) prove you are insolvent (which means you owe more than you own) after the debt forgiveness.

But that’s not where it ends, you have to also file a Form 982 with your tax return. Plus, remember that this tax may still be due on a state basis. Many states are not following the fed’s lead on this.

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