Walking Away from Your Mortgage Can Have Hidden Tax Consequences

Should you walk away from your mortgage if you owe too much money? It depends.

One highly important factor, which I feel is getting very short shrift in the conversation about debts, is what the rest of your financial picture looks like. We writers like to key our personal finance advice to the widest possible audience, but personal finance is never one-size-fits-all.

Today's example is from The New York Times, a newspaper which has relatively rich readers (with a median household income of $119,317, according to the Times' own advertising materials). Yet suddenly this highbrow publication is running stories on walking away from your mortgage.

The Times story on sending the keys back to the bank, published Tuesday and written by David Streitfeld, posits that by June, people who are deeply underwater on their mortgages -- where the value of the home is 75 percent of the mortgage balance, or even less -- will reach 5.1 million.

The Times' context for this is that that's about 10 percent of all Americans with mortgages. The paper forgot to add, of course, that there are many people in this country who own their homes outright. In fact, according to the Census Bureau, the number of "free and clear" units is just under 24 million.

I'm not trying to minimize the suffering of the millions of people who are deeply underwater, just trying to put in perspective that this is a problem that affects only a thin slice of American homeowners.

But more importantly, the Times piece ignores one of the strongest consequences of ditching your house, which is that you may still have some pretty hefty taxes to pay.

Let's use, as an example, a $215,000 condo in Miami. This is the property that the Times story starts off with, and it's described as "a plain one-bedroom."

The story doesn't describe the loan on the condo, but given that it was bought in 2006, it's probable that the buyer put down 5%, and so took out a loan of $204,000.

Now if one could rent a better apartment now for the price of one's house payments, and buy a similar apartment now for $90,000, the thing to do is to toss the property with the $204,000 debt, right?

Well, there are obviously ethical questions as to whether one wants to default on a contract, and practical questions as to whether there will be repercussions (a lowered credit score, say). However, let's just look at the economic calculation: a lot of that depends on what the tax treatment is on the spread between the $204,000 one owes the bank and the $90,000 that the bank is going to get from a subsequent sale.

If that difference between $204,000 and $90,000 is treated as a debt that's been forgiven, then it's really, in some sense, income -- meaning that it's possible that the homeowner has just "earned" $114,000.

If we're dealing with a 33% tax bracket, that's $37,000 that's due to the IRS -- which is a lot to pay for a better rental.

The reason I point this out to you, dear readers, is that this kind of tax consequence is exactly what might pop up if you choose to ditch a vacation home. There's a tax act called the Mortgage Forgiveness Debt Relief Act of 2007, but if you read the IRS FAQ on tax treatment of foreclosure income carefully, you'll see that not all is forgiven.

If you're underwater on your mortgage and you've got a job, stay the course. If you're unemployed, that's a different story -- just make sure that you talk to an accountant first.