If the economic havoc from the coronavirus persists, distressed homeowners could find themselves facing a terrifying prospect next year: Foreclosure.
The CARES Act, the pandemic relief act that became a law this spring, sought to keep millions of Americans in their homes.
In particular, it gave borrowers with federally backed mortgages the ability to request a pause in payments – forbearance – for up to 180 days if they were facing financial hardship. Those borrowers could also ask for another 180 days of relief.
The law further barred lenders and servicers from foreclosing on borrowers with federally backed mortgages – as well as those backed by government-sponsored entities Fannie Mae and Freddie Mac – from March 18 through Aug. 31.
The Federal Housing Finance Agency said on Thursday that Fannie Mae and Freddie Mac would extend its foreclosure moratoriums until at least Dec. 31, granting borrowers with single-family mortgages four more months of relief.
Foreclosures – the process through which a lender will seize and sell a home after a borrower defaults on the mortgage – have been trending downward over time.
In July, there were 8,892 properties in the U.S. with foreclosure filings, down 83% from a year ago – an example of how the CARES Act protections have worked this year, according to ATTOM Data Solutions.
But as more people lose their jobs and those federal protections eventually expire, foreclosure numbers may tick up in 2021.
"We're anticipating that due to Covid itself and the unemployment impact, we're expecting about another 1 million additional foreclosures over the next 18 months," said Todd Teta, chief product officer at ATTOM.
Worse still, there are tax complications with the forced sale of a home.
"If the creditor has made reasonable attempts to collect on a debt and chooses to forgive it rather than pursuing other remediation, then the difference that's written off is taxable," said Mark Alaimo, CPA and member of the American Institute of CPAs personal financial specialist committee.
Debt cancellation and taxes
Generally, if you're in default with a creditor and you reach a deal such that you're able to resolve it for less money, the amount that's forgiven is deemed taxable income.
For example, you owed $5,000 on a credit card, but you're unable to pay the full sum. You settle the debt for $3,000 instead. That means you'll incur $2,000 of taxable income – the amount of debt your creditor cancelled.
The rules are a little different for your home.
If the foreclosed home is your principal residence, a special tax break known as the qualified principal residence indebtedness exclusion may allow you to exclude up to $2 million (if married) of the forgiven debt.
Here's the catch: This tax break is a temporary provision that must be renewed by Congress.
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Indeed, lawmakers revived this so-called "tax extender" at the end of 2019, but it will only apply to debt discharges occurring before Jan. 1, 2021.
"If we don't get an extension of the 'loss of principal home' exclusion and we're in a place where real estate values have gone down, then you're going to have a problem," said Ed Zollars, CPA at Thomas & Zollars in Phoenix.
Whether the cancelled debt is a mortgage or a credit card, your creditor will send you a Form 1099-C, spelling out the details on how much was forgiven.
Receipt of the 1099-C is often borrowers' first tip-off to the surprise.
"People are blindsided thinking that losing a home could create taxable income," Zollars said. "They're thinking, 'How could I owe taxes? I didn't get anything.'"
Talk to your tax professional
Aside from the exclusion for principal home indebtedness, there are other scenarios in which a debt cancellation may be excluded from your income.
This includes bankruptcy and insolvency – and you'll need to work with a tax professional to move forward.
Claiming that you're insolvent will require a thorough accounting of all of your assets and liabilities.
"We can figure out if they were insolvent on the day the debt was forgiven, but I need to know the values of everything, including brokerage accounts, 401(k) plans, and individual retirement accounts," Zollars said.
The best thing to do is to head off the foreclosure at the pass and develop a plan with your bank or servicer to address late payments before they begin to snowball.
"The first thing is to be proactive with your lender, give them updates and make sure that they know what's going on," Alaimo said.
