Why Troubled Homeowners Could Face Huge Tax Bills

Financial adversity is an unhappy fact of life — jobs are won and lost, savings stashed and spent, and investments gain and lose ground all the time.

Certain reversals of fortune are within our ability to predict and prevent. Indeed, some losses may even be manageable. Others, though, are impossible for some to overcome.

Apparently, lawmakers felt that way when they enacted the Mortgage Forgiveness Debt Relief Act in 2007 — legislation that exempted from personal income taxes the portion of mortgage-related debts that were forgiven by lenders in the aftermath of the crisis.

When the repayment of some or all of a loan obligation is waived — such as in the case of a mortgage short sale or some other type of modification that reduces the unpaid balance of a loan — the IRS views the forgone amount the same as if it were paid as ordinary income. Fully taxable income, that is.

So Congress set out to shield borrowers against the financial perversion that would ensue when debts are forgiven with one hand and taxed with the other. The resulting legislation was originally intended to remain in place through 2012. It was later extended through 2013.

As the New York Times points out in a recent story, however, the financial gotcha that lawmakers sought to head off is now being visited upon consumers who thought they were being helped.

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The Downside of Relief

As of Jan. 1, 2014, borrowers are now required to pay taxes on the forgiven values of their mortgage-related debts, just as banks have begun to write them off. The difference, of course, is that consumers are on the “paying” side of the equation while lenders are on the “receiving” end. That’s because of the tax deduction that may be claimed when the write-off is for previously recognized (and taxed) profits and/or diminished loan balances.

That seeming disparity notwithstanding, the discontinuation of the special tax exemption poses serious challenges for financially strapped consumer-borrowers who were granted relief. To start, given their present circumstances, it’s unlikely they have enough extra cash on hand to pay their tax bills in full. It’s equally improbable that they’ll be able to obtain reasonably priced financing, especially if their houses were sold or their mortgages were adjusted downward to their properties’ current market values.

So when paying cash or being approved for a low-rate loan that’s supported by high value collateral isn’t in the cards, borrowers have two choices.

The first would be to search for unsecured financing. The issues, however, are the high rates this type of financing commands, and the stringent terms that may be required if the loan is approved in the first place.

The second would be to borrow from the source of their economic pain: the federal government.

Paying a Big Tax Bill

The IRS offers installment payment plans to consumers who are unable to fully pay their tax obligations when due. In fact, the service relaxed the rules for this accommodation two years ago. As a result, taxpayers now have up to 72 months (six years) to repay their debt. The fees are modest and the rates are low (currently between 3% and 4%).

The key, however, is to always remember which entity it is that you’re borrowing from.

Your remittances must be made on time and in full. Otherwise, the IRS may take enforcement actions that can include the filing of federal tax liens against all your other possessions. Also know that any tax refunds to which you may be entitled in the future will be used to offset your remaining obligation.

Of course, the best approach would be to extend the mortgage forgiveness act during this period of tenuous economic recovery. In fact, while we’re at it, let’s also expand it to cover the portion of student loan debts that are forgiven.

It’s tough to rationalize taxing the relief that the government is advocating for lenders to offer when it is itself the single largest student lender that just so happens to be the single largest grantor of debt-relief as well.

This glaring inconsistency is nothing less than a financial sleight of hand.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.