Deeds in lieu of foreclosure and short sales in N.J.: Beware of phantom income | Economy | -- Your State. Your News.

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Deeds in lieu of foreclosure and short sales in N.J.: Beware of phantom income

moneyhouse_optBY GERALD J. ROBINSON

Say your home is under water and your lender is threatening foreclosure. You're not in a position to make anymore mortgage payments and your efforts to get your lender to reduce your payments were fruitless.

If your lender forecloses on our home and sells it for a price that's insufficient to cover the unpaid balance you owe on your mortgage loan, New Jersey law permits the lender to pursue you for the unpaid balance. The lender can get a "deficiency judgment" against you that can haunt you for years.

But there may be some good news. Sometimes your lender will say that if you voluntarily hand over your deed, the unpaid balance of your mortgage debt will be forgiven. This "deed in lieu of foreclosure" arrangement means the lender won't seek a deficiency judgment against you.

Or sometimes you can work out a "short sale" in which the unpaid balance of your mortgage is forgiven if you turn all the proceeds of the sale over to the lender. This also can get you off the hook for a deficiency judgment.

Don't jump for these solutions until you've checked for "phantom income."

Phantom income is income you're taxable on even though you don't see it – you don't get any money. A prime example of phantom income is debt forgiveness income. The tax code generally says you have taxable income when you have a debt that is forgiven – as in the deed in lieu of foreclosure and short sale situations. Reason: even though you don't see any money, you're richer by the debt that's wiped out for free.

But you may get lucky. The Mortgage Debt Relief Act of 2007 provides that no phantom income is recognized for certain debt discharges on mortgage son individuals' principal residences. This break applies for debt forgiveness after January 1, 2007 and before January 1, 2013 if the mortgage debt forgiven was incurred to acquire, construct or substantially improve your principal residence. The cap on the amount of home mortgage indebtedness that can qualify for this break is $ 2 million.

With this break, it may seem that you're off the hook when your home mortgage debt is forgiven. But the taxman's hand may be quicker than the homeowner's eye. Note that the relief applies to mortgage debt forgiveness that was incurred "to acquire, construct or substantially improve" your principal residence.

Suppose your mortgage debt came from a refinancing, a second mortgage or a home equity line of credit where the proceeds were used for a purpose other than to acquire, construct or substantially improve your principal residence. The proceeds of many such loans were not used for these purposes but for other purposes, such as to make a down payment on a second home, buy a car, pay college tuition or medical bills or take a vacation.

If you don't qualify for the forgiveness, it could cost you thousands of dollars in taxes.

There's not much wiggle room to escape this result. If you can show you're insolvent both before and after the debt forgiveness, there is no phantom income. Moreover, there is no phantom income if the debt is discharged in a Title 11 bankruptcy case. A generous appraisal can cut down on the amount of phantom income, provided it's not unreasonable.

If you're facing home foreclosure, you should know the tax rules about phantom income. Additional information regarding these rules can be obtained from IRS Publication 4681,Cancelled Debts, Foreclosures, Repossessions and Abandonments. The publication can be found here.

Comments (1)
1 Friday, 03 August 2012 09:15
Deborah Kelly
Can you, in fact, force a Deed in Lieu of Foreclosure

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