Thinking About a Mortgage Default? Beware The Taxes Due

If you walk away from a mortgage you don't want any more, what are the consequences? I wrote about the moral and credit implications in a previous post. A reader emailed to ask about the federal tax implications. "In my state, the banks send a notice saying that you owe taxes on the unpaid debt," he wrote.

He's right. In many states, any part of a mortgage that the bank forgives is reported as taxable income.

In some states, you're off the tax hook if the bank forecloses on your original mortgage. But you could still be taxed on a home equity loan or a loan you refinanced.

You've probably heard that the government has temporarily stopped taxing people who lose or give up their homes. That's the Mortgage Forgiveness Debt Relief Act (otherwise known as "The Don't Kick 'Em When They're Down Act"). But it doesn't apply to every mortgage. You can be foreclosed and get a tax bill, too.

The majority of people going through foreclosure have no choice. They can't afford the payments any more.

But a growing number of homeowners are choosing "strategic default." They're not broke. They owe more than the house is worth and decide to stop throwing good money after bad.

Many considerations come into the default decision -- moral, reputational, financial, credit-score, and what the kids will think. Taxes matter, too. Here are the questions to ask:

What might I owe taxes on? You're generally taxed on debt that a lender forgives. For example, say that you default on a $350,000 first-mortgage loan. The bank sells the property for $250,000. If the bank has the right to pursue you for the remaining $100,000 but doesn't, that "forgiven" amount is taxed to you. States with these rules are called "recourse" states.

The Debt Relief law wipes out the taxes due, but only for certain types of loans (see further below).

In some states -- called "non-recourse" states -- a bank that forecloses generally does not have the right to chase you for additional money. As a result, the unpaid debt ($100,000, in this example) is not taxed as income. You get away scot free. For lists of non-recourse states, see here and here.

Be warned that the tax-free laws in non-recourse states cover only three types of loans: (1) the original mortgage you took when you bought or built the home; (2) the current balance of the original mortgage, when you refinanced; or (3) a cash-out refinancing or home equity loan where the proceeds were used to substantially improve the home.

If you borrowed against your home for another purpose -- say, to repay credit card bills or buy a car -- there's no tax protection. Also the loans have to be on your principal residence, not a second home.

There's an exception. You'll owe no taxes, regardless of the type of loan, if you're bankrupt or insolvent.

What if I went through loan modification instead of foreclosure? The same tax rules apply. If the loan mod reduces the principal balance, that sum is potentially taxable.

What if I did a short sale, where the lender let me sell the house for less than I owe? Same rules. Forgiven debt is potentially taxable, regardless of the source.

How does the Debt Relief law help? From now through 2012, you owe no taxes on certain types of forgiven mortgage debt. The loan has to be on your principal residence, for money to buy, build, or substantially improve the home.

Taxes are normally not forgiven on cash-out refinancings or home equity loans used for other purposes, such as repaying credit card debt. You're exempted only if you're bankrupt or insolvent.

You'll also owe taxes if you walk away from a giant debt. The exclusion applies only to unpaid loans up to $2 million ($1 million if you're married and filing separately).

Is the Debt Relief law a free lunch? Usually, but not always. Say that you took a loan modification and stayed in the house. The amount of debt forgiven is subtracted from your "basis" -- that is, the amount that you paid for the house, plus the cost of substantial improvements and minus any depreciation. If you eventually sell at a profit -- defined as the difference between your basis and your net selling price -- you'll have a larger capital gain than if you had never modified the loan.

You'll also have a capital gain -- in this case, a phantom gain -- if you walk away from a loan that's larger than your basis, says real estate expert Jack Reed. That's common in homes that are underwater.

You can shelter all or part of these capital gains. The first $250,000 in profits ($500,000 if you're married) passes tax free.

What if I walk away from a second home or rental property? There's normally no tax forgiveness, even in non-recourse states. You'll owe full taxes on the amount of debt that the bank writes off.

Will the bank issue a 1099? Yes, if any debt is forgiven. To get the tax break under the Debt Relief law, you'll have to file Form 982 with your tax return. For the rules, download Publication 4681 from the IRS website -- but in truth, it won't help. "It's beyond the understanding of most people," says tax expert Julian Block. I agree. Get professional advice.

More on MoneyWatch:
What Happens When You Walk Away From a Mortgage Loan
Mortgage Default: What Would You Tell the Kids?
The Rich are Different: Maybe Another Reason to Curtail Mortgage Subsidies
Strategic Defaults Increasing as Homeowners Choose Not to Pay Their Mortgage