Tags: phantom | tax | real | estate

Expiring Tax Exemptions of Phantom Income on Real Estate Loans

Monday, 05 Nov 2012 07:46 AM

By Denis Kleinfeld

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A key component supporting the market valuations for investments in the overall real estate sector is the residential real estate market.

On Jan. 1, all of today’s projections and prognostications of a real estate recovery goes out the window.

And with that, investments tied to the real estate markets and bank loans lose any form of real predictability.

As of now, there are hundreds of thousands of homeowners in default of their mortgages, and even more are very close to the line.

Until Dec. 31, the phantom gain from loan modifications, foreclosures or forgiveness of debt on short sales can potentially be exempted.

This cancellation of debt income arises when money is borrowed from a commercial lender and the debt is later cancelled or forgiven under certain circumstances.

Lenders are required to report the amount of the cancelled debt to the IRS on Form 1099-C.

Even if the lender overlooks sending in Form 1099-C, the taxpayer is still required to pick the cancellation of debt (COD) income as taxable income.

An exemption from recognizing this COD income is when a qualified principal residence is involved. The types of debt that is considered qualified are loans used to buy, build or substantially improve a taxpayer’s principle residence or to refinance it.

Expensive homes are subject to a $2 million limitation if the taxpayer is married or $1 million if filing separately.

It is possible to use another provision of the tax code that provides for an exemption due to being insolvent. Then, only to the extent of the insolvency, does the taxpayer avoid recognizing phantom income.

The tax rules involved are, of course, much more complicated, but this gives you the basics.

These tax rules allow taxpayers who are upside down on their mortgages, or can no longer afford to pay their mortgage, a way of avoiding a double-loss whammy.

That is, not only losing any money they invested in their residence, but then also getting hit with income tax when they haven’t actually gotten any money out of the house.

In 2007, when the bottom starting dropping out of the real estate markets, Congress, in a grand show of generosity, enacted the Mortgage Forgiveness Debt Relief Act, which bestowed on taxpayers losing their houses to be forgiven, albeit temporarily, a phantom tax that they couldn’t afford to pay anyway.

This tax emption from recognizing phantom income encouraged a lot of taxpayers to work out loan modifications or short sales. This resulted in the rise of residential real estate sales, which are touted by experts to prove the real estate market is recovering.

Whether it does or does not, the exemption ends on Jan. 1.

It is Congress’ way of saying Happy New Year to a struggling, if not failing, economy.

The end of the year is rapidly approaching and decisions about investments in real estate can no longer be put off.

The rate on capital gains is going up and who knows what the tax law will be next year. Right now, things are not looking good.

With tax exemptions gone, there will be little to encourage homeowners to voluntarily engage in short sales or loan modifications.

For homeowners in this unfortunate position, they might as well just stay in the house, let some lawyer fight foreclosure if and when it comes about and enjoy living in a house for free for who knows how long.

Homeowners are not the only ones at risk of loss. Investors in the real estate markets, and not just residential properties, also have money on the line.

The expiring tax exemptions and the low or no rate of economic growth will have a profound impact on the real estate investment markets.

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