About 11 million U.S. homeowners owe more than their homes are worth, according to real estate data firm CoreLogic, and while taxes may not be the first thing they think about in deciding what to do, all the various options have tax consequences.
Until the end of this year, at least, there is a tax break for homeowners who negotiate debt reduction with their lenders.
Some of these “underwater” owners may qualify for principal reduction through the massive mortgage foreclosure settlement announced in February. Others may pursue short sales, in which the home is sold for less than the bank is owed, or wind up in foreclosure.
But those whose lenders cancel their debt would ordinarily face the tax man, because cancellation of debt, including mortgage reduction, is generally taxable. That means if you get your mortgage reduced by $100,000 and you’re in the 28% tax bracket, you’d owe $28,000 in federal taxes on the “income” you received when your debt was forgiven.
Typically, the only way to avoid those taxes is to declare bankruptcy or to claim insolvency, which does not require a bankruptcy filing but still requires that your debts outweigh your assets. Being foreclosed in a state like California, which has “non-recourse” rules that prohibit lenders from coming after you for extra cash after they’ve taken your house, also exempts one from taxes. More