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Avoid paying taxes on forgiven mortgage debt

(MoneyWatch) It could be the ultimate tax kick in the gut -- if you don't know how to stop it.

A new federal rule regarding the tax treatment of mortgage debt forgiveness may soon change, requiring homeowners who qualify for principal reduction under the government's Home Affordable Modification Program, or HAMP, to wind up footing a huge and, in many cases, unaffordable tax bill. But there is a way to avoid paying these taxes.

For the past five years, and for the remainder of 2013, homeowners were not required to pay taxes on mortgage debt on their primary residence they are released from paying back. Such forgiven debt usually arises from lenders reducing how much principal borrowers owe on a loan, foreclosure or a short sale, which is when a property is sold for less than the value of the mortgage.

Today, homeowners eligible under HAMP for the so-called Principal Reduction Alternative program are granted a reduction in their mortgage balance, among other options, so that their monthly mortgage payment is no more than 31 percent of their gross income. The reduction is typically deducted from the loan over three years, during which the homeowner must continue to pay their mortgage on time.

In normal years, the IRS would tax any reduction in mortgage principal as ordinary income at the homeowner's marginal tax bracket. But under the Mortgage Forgiveness Debt Relief Act of 2007, enacted shortly before the financial crisis would erupt as a way to stem what was then a rising tide of foreclosures, the IRS allows this reduction to be tax-free.

But there is a question about whether the debt-reduction program will continue to be tax-free, or whether, starting in 2014, the old rules apply. It is unclear how many Americans, millions of whom remain "underwater" on their haves, have damaged credit, and have been nearly wiped out financially would be affected.

Yet there is a way out. According to the IRS, participants in the principal reduction program may claim all of their principal reduction in 2013 and not pay a dime in taxes, regardless of whether Congress extends the mortgage forgiveness law another year or more.

"Anyone who is willing to wade through the rules can see that they've got some alternatives," said Brant Goldwyn, an editor at tax and accounting services firm Commerce Clearing House.

Midway through a 23-page document on the IRS' site explaining the tax implications of principal reductions on HAMP participants, there is an option that anyone who in the program or who is thinking about applying for HAMP can choose.

"They can simply change their reporting from reporting it over three years to reporting it all at one time," Goldwyn said. "The key is that they're able to exclude it this year, so that it won't change the taxable income."

Even people who were initially set to receive the reductions over three years can change their reduction schedule, claiming the entire reduced principal in their 2012 or 2013 taxes using Form 982. This move would exclude the mortgage debt from income tax requirements, making it tax-free. Anyone concerned over the tax implications of their principal reduction should contact a HAMP housing counselor or a tax professional.

The bottom line: Homeowners don't have to take the financial hit of paying for taxes on a principal reduction. They also don't have to simply wait and hope that lawmakers will extend this mortgage relief in the future, a risky proposition these days given the partisan feuding in Congress.

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