Home Short-Sellers Could Face a Huge Hidden Tax

BOSTON (TheStreet) -- Down-on-their-luck homeowners who avoid foreclosure through short sales or loan forgiveness could owe the IRS big bucks because partisan wrangling is holding up extension of a popular tax break designed to help them.

"We're talking about people who are financially distressed and simply don't have the wherewithal to pay this tax liability," says Steve Brown, president of the National Association of Realtors. "If they had the money, they wouldn't be in distress."

Before 2007, homeowners who worked something out with their lenders to avoid foreclosure would find suddenly that the Internal Revenue Service treated any principal a bank forgave as taxable.

Say you owed $400,000 on a home whose value had dropped to $300,000 because of the housing bust, but you couldn't afford to either keep up the mortgage payments or sell the place and make up the $100,000 shortfall.

If you got the bank to agree to a "deed in lieu of foreclosure" taking back the house and forgoing the remaining $100,000 the IRS would consider the unpaid principal as "income" on which you owed taxes. You'd owe potentially as much as $30,000 or more on the money (and possibly state income taxes as well) even though you were probably broke.

Also see: 5 Cities That Aren't Seeing a Housing Recovery

Taxes also applied if you got a "principal reduction," in which you stayed in the home and the bank agreed to reduce your loan balance because it's not worth foreclosing, or if you did a "short sale" in which you sell your home at market prices and give the bank all proceeds, with the lender forgiving any amount over the sale price.

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