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Bankruptcy May Shield Homeowners From Forgiven Mortgage Debt Tax (1)

Oct. 28, 2019, 8:46 AMUpdated: Oct. 28, 2019, 8:46 PM

Declaring bankruptcy may be a last-ditch option for homeowners who lost a tax break on mortgage debt they had forgiven after the foreclosure or short sale of their home.

“If they’re suddenly facing what could potentially be tens of thousands of dollars of IRS debt, that’s going to be an incentive to file a bankruptcy that might not be filed otherwise,” said Geoffry Walsh, a staff attorney at the National Consumer Law Center who focuses on foreclosure prevention, consumer bankruptcy, and other consumer credit issues.

For a decade prior to 2018, individuals who had mortgage debt forgiven or canceled because they lost their primary residence through a foreclosure or a short sale could exclude up to $2 million of that amount from their taxable income.

The provision expired at the end of 2017, along with dozens of other temporary tax breaks. And now with Congress’s attention consumed by impeachment proceedings and other end-of-the-year priorities, the hope of renewing those tax perks in the near term is dwindling.

In the absence of that provision taxpayers can potentially turn to tax relief available under other parts of the tax code. Individuals who are insolvent—meaning they’ve proved to the IRS that their liabilities exceed the value of their assets—or are in bankruptcy can exclude canceled debt from their taxable income. That can spare them from having to pay taxes on tens of thousands of dollars in additional income, if not more.

Taxpayers will have to consider whether the tax savings outweigh the negatives of these alternatives. In bankruptcy, for example, individuals risk losing certain “non-exempt” assets that the court can sell to pay back creditors.

Timing is another important factor. Individuals should file for bankruptcy before tax is assessed because there are limitations and more complicated rules for discharging tax debts, Walsh said. This opportunity may have already passed for taxpayers with canceled or forgiven mortgage debt who had tax assessed in 2018.

Walsh noted that in bankruptcy individuals discharge more than just the debts associated with their mortgage. So they could have other types of debt—credit card debt, medical debt, etc.—that they may have otherwise found a way to pay if it weren’t for the massive tax bill on their forgiven mortgage debt, he said.

Renewing the tax break would be better for taxpayers, the court system, and the IRS than killing it permanently and pushing people into bankruptcies that otherwise wouldn’t happen, said Julia Gordon, president of the National Community Stabilization Trust, which works to restore vacant and abandoned properties.

Narrowing of Tax Break

Lawmakers have given the tax break less attention in recent years than other expired provisions with stronger lobbying presence behind them—such as credits for the biodiesel and short-line railroad industries.

The lack of urgency stems in part from the rebounding housing market years after the financial crisis of the late 2000s. The tax break was first signed into law in December 2007 to help taxpayers cope with the effects of that crisis.

But proponents of the provision note that there are still plenty of individuals facing hardship.

The National Association of Realtors in an August 2019 report submitted to the Senate Finance Committee said there were more than 360,000 U.S. homes in foreclosure last year, based on data from the Mortgage Bankers Association.

“While this is significantly lower than the approximately 2 million homes in foreclosure during the depth of the Great Recession, the current number is still surprisingly high given the strength of today’s economy and job market,” the group said.

The group recommended making the tax break permanent at a reduced level and tightening the eligibility conditions. For example, NAR advocated for creating restrictions to prevent borrowers who haven’t attempted to work with their lenders “in a responsible way” from taking advantage of the relief.

If permanence is not possible, the realtors’ group proposed that Congress extend the provision in its current form.

According to a lobbying disclosure, the organization spent $8.2 million on lobbying in the third quarter, including on S. 617, the tax extenders bill Senate Finance Committee Chairman Chuck Grassley (R-Iowa) and ranking member Ron Wyden (D-Ore.) introduced in February.

The number of taxpayers who claimed the exclusion in 2018 for the 2017 tax year was relatively small, but the dollar amounts were substantial.

Almost 565,000 taxpayers reported canceled debt income on their tax returns valued at a total $6.25 billion, according to IRS data.

About 148,000 individuals claimed tax breaks on canceled debt income—15.5% of which were exclusions for forgiven mortgage debt on a primary residence. In total that subset of taxpayers excluded about $2 billion from their gross incomes. Data for the 2018 tax year isn’t yet available.

Few Objections

Critics of extending the exclusion argue that the tax break encourages homeowners to be less responsible about fulfilling debt obligations, said Ray Beeman, principal and co-leader of the Washington Council Ernst & Young practice of Ernst & Young LLP.

They say it results in people who pay their mortgages receiving worse treatment than those who don’t, said Beeman, who is also a former tax counsel to the House Ways and Means Committee.

Despite the criticism, the tax break is unlikely to face a lot of opposition from lawmakers. Still, action on expired extenders is part of broader negotiations.

“I don’t think there are a lot of lawmakers against it,” said Dustin Stamper, managing director in Grant Thornton LLP’s Washington National Tax Office and leader of its tax legislative affairs practice. “It’s more about extenders in general and the fact that it’s been hard to get legislation done.”

Beeman said he’s less optimistic than he’s been in the past that Congress will pass an extenders bill. Talk of dealing with those provisions in a substantive way—eliminating some and making the others permanent—has died down, he said.

Grassley has placed the blame on congressional Democrats, saying they’ve shown little interest in working on extenders.

Sen. Robert Menendez (D-N.J.), a member of the tax-writing committee, said Democrats are willing to work on passing the temporary tax provisions, but Republicans want to include fixes to the 2017 tax law without offering anything meaningful in exchange.

It’s possible that the tax break for forgiven mortgage debt could be part of a “skinny” extenders bill, Menendez said.

“I’m hopeful it can be. But I have a feeling that the chairman is holding everything hostage,” he said.

A spokesperson for Wyden (D-Ore.) said the senator supports extending the exclusion for homeowners and that it would be considered as part of negotiations.

Forthcoming appropriations legislation may be the best shot for extending the temporary tax provisions. But if lawmakers move a short-term stopgap to fund the government beyond Nov. 21, the tax benefits that expired at the end of 2017 will have been dead for more than two years by the next funding deadline.

“The farther you get from the year in which people are actually claiming the credits, the less momentum there will be,” Stamper said.

—With assistance from Kaustuv Basu.

(Updates with additional comments from the National Association of Realtors in the 16th paragraph. An earlier version corrected the 20th paragraph to clarify that individuals are not necessarily linked to IRS data referenced in the 19th paragraph.)

To contact the reporter on this story: Allyson Versprille in Washington at

To contact the editors responsible for this story: Patrick Ambrosio at; Colleen Murphy at