There is a little known provision in the income tax code (most of the thousands of pages contain little known stuff) that basically says that if someone releases you from your debt obligation then you’ve earned income equal to the amount of debt forgiven. Normally that makes sense. If I loan you $10,000 and then 2 weeks later tell you that you don’t have to pay me back then basically you’ve just earned $10,000.
The only problem is that there are now millions of people underwater on their mortgages who have no money in the bank and they are either looking to have their principal reduced or they are facing foreclosure or they are doing a short sale – all of which will result in a debt reduction. Regardless of the ultimate resolution of their financial problems under normal circumstances these people would have to pay income tax on this phantom income. But in today’s environment these people don’t have the money to pay these taxes and talk about adding insult to injury!
So in 2007 congress passed the Mortgage Debt Relief Act, which relieves people of the obligation to pay taxes on this phantom income – but only through the end of 2012 and only for debt on a principal residence. So, if you need to take advantage of this temporary provision you are running out of time. This is just one element of the fiscal cliff you keep hearing about us running off of at the end of the year – unless congress acts to extend the Debt Relief Act.
Fortunately, the Senate Finance Committee recently approved a bipartisan (that helps) bill that extends the Debt Relief Act through the end of 2013. Of course the bill still has to go to the Senate and probably the House for approval. Actually, I don’t know the process but the video below explains it pretty well. Anyway, if you are contemplating getting out from under some of your mortgage you either need to do it now or keep your eyes on congress and pray for relief.