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May 18th, 2010

Thinking About Walking Away? Consider the Tax Hit

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We’ve touched on the moral hazard that’s involved in walking away from your mortgage, but this post is designed to warn you of the tax liabilities that can incur after you walk away (a.k.a. letting your home fall into foreclosure even though you can still afford to make payments) from your home:

“I had no clue this would happen,” says [Maxine] McDaniel [who walked away from her Colorado home earlier this year]. “I just thought I’d get out from under the house and that would be that,” she says.

According to the IRS, walking away from your home doesn’t mean you’ve walked away from your financial obligation:

That transaction caused [Ms. McDaniel] problems because, while canceled debt originally used to buy or build a house can be exempted from tax filings, debt used for other purposes cannot.

Federal and state tax laws have long viewed canceled debt as income because consumers who borrow money to buy a house—or who pull money out of their house to buy cars and such—and then don’t pay it back “wind up ahead of where they were,” says an IRS spokesman.

What’s perhaps ironic, is that the predominant reason borrowers walk away from their mortgage, is because it is a “business” decision. Borrowers who strategically default tend to ask themselves, “Will I lose less money in the long run by staying or leaving?” Yet it appears those who have decided to leave may get a big surprise come tax time:

“People think their house was underwater, so they’re insolvent and can get out of owing taxes,” says Arthur Auerbach, a member of the Individual Income Tax Technical Resource Panel at the American Institute of Certified Public Accountants. “But it doesn’t work that way.”

These tax rules don’t just pertain to foreclosures. If you have utilized one of the government’s efforts to avoid a foreclosure – such as HAMP, 2MP and HAFA — there are important tax laws that pertain to those as well:

The government’s new, expanded modification programs include short sales, in which a bank agrees to accept as full payment less than the value of the mortgage balance; deed-in-lieu transactions, when a homeowner gives the house to the bank instead of repaying the mortgage; and second mortgages such as home-equity lines of credit.

In many of those instances, say Treasury officials, homeowners used mortgage money to fund everything from tuition and medical bills to vacations and cars and even the down payment on a second home or investment property. That debt, however, isn’t eligible for exemption.

It appears that the tax liability comes as the result of a cash-out refinance, principal reduction or another form of a large cancellation of debt.

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3 Responses to “Thinking About Walking Away? Consider the Tax Hit”

  1. Tweets that mention Thinking About Walking Away? Consider the Tax Hit | HSH Financial News Blog -- Topsy.com Says: May 18th, 2010 at 8:34 am

    [...] This post was mentioned on Twitter by HSH Associates. HSH Associates said: Thinking Bout Walking Away? Consider the Taxes http://bit.ly/9ek9U4 Liability: could b result of cash-out refi, principal reduction or la… [...]

  2. Mitch Says: May 20th, 2010 at 1:36 am

    Man, that suddenly doesn’t seem fair, does it? House is worth nothing, yet the government still wants to tax you as though it does. Communities are doing the same thing, not reducing the amount of taxes based on what a house is presently worth because they need the money themselves.

    This is why I’m so glad I live in New York and don’t have to deal with things like that.

  3. Tim Manni Says: May 20th, 2010 at 8:35 am

    Hey Mitch,

    Thanks for commenting. Think about this: the government reduces your debt load by a significant amount (say a principal reduction). Then shortly after, you just walk away from your home loan, not making another payment. Does that seem fair to everyone else? Although these people may be in a financial bind, the IRS sees this as added income — income you didn’t have before.

    Something to think about,
    Tim

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HSH.com's daily blog focuses on the latest developments in the mortgage and housing markets. Our mission is to relate how changes in mortgage rates and housing policy, as well as the latest financial news, impacts consumers, homebuyers and industry insiders alike. Our 30-plus years of experience in the mortgage industry gives us an edge as we break down the latest changes in an ever-changing market.

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Tim Manni

Tim Manni is the Managing Editor of HSH.com and the author of their daily blog, which concentrates on the latest developments in the mortgage and housing markets.

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