In the recent times, the Obama government as well as the private lenders have started considering principal reduction programs for homeowners who are underwater. However, the Internal Revenue Service (IRS) has issued a new advisory to taxpayers who would get such assistance from the lenders. Let's check out how the principal reduction on underwater mortgages will affect the taxpayers:
- Loans on which the taxes are forgiven - Most people have the wrong opinion that the federal tax exclusion applies to all types of home loans. However, it is not so. It applies to mortgage balances on principal residence only. Second homes, rental or business property are excluded from the tax forgiveness.
- Debt amount to be forgiven - The maximum debt which can be forgiven under the law is $2 million for married taxpayers filing jointly and $1 million for single filers.
When can you claim tax deductions?
There are certain grounds on which principal debt would be reduced. Principal reduction will be done by the lender only if the loan has been used to build, buy or improve one's primary residence. If you've used the loan amount to pay off credit card bills, buy cars or invest in stocks, then it won't be considered eligible for tax exclusion.
What happens after your taxes are forgiven by the lender?
After the lender forgives a part of your mortgage balance, the lender will issue an IRS Form 1099-C. This is a notice of "Cancellation of Debt" and this form is also sent to the IRS. The form shows the fair market value (FMV) of the property and the amount of debt discharged/forgiven by the lender.
How can you claim exemptions on the forgiven debt?
You will have to download IRS Form 982 from www.irs.gov and attach it to your tax return. However, this tax benefit is available till 2012.
When shouldn't you claim tax exemption?
You won't be able to claim tax deductions if your property has been foreclosed upon by the lender or if you go for a short sale and lose money in the process. However, after the foreclosure if your lender forgives the balance amount, then you can file an exemption with the IRS.