There is a good news/ bad news side of owing money if you're a borrower in trouble with mortgage debt. The good news is that your lender might be willing to renegotiate your loan to give you a break on your payments. Foreclosure is expensive and it is also bad publicity throwing people out of their homes. Lenders simply do not like to do it, and they don't want to own your house. They just want to collect the mortgage payments. Now for the bad, news: The IRS is watching.
Lenders are required by law to report to the Internal Revenue Service (IRS) any amount of debt forgiven to customers. That means that unless you file bankruptcy or are otherwise declared insolvent in court, you will probably owe federal tax on the amount forgiven.
There is no question that thousands of Americans are in trouble with mortgage debt, particularly those who might have gotten low or no-down payment loans that have actually raised monthly payment amounts as interest rates have risen. Some of these loans were structured in a way that as rates have gone higher that the loans were sent into "negative amortization" -- where any equity is erased and the borrower finds they actually owe more on the loan than the amount they originally agreed to.
Add a potential tax debt to that situation, and we may see an entire class of borrowers risking the loss of everything they own.
Fortunately, Congress is trying to deal with the problem. Right now, a bill in the U.S. House of Representatives entitled "The Mortgage Cancellation Tax Relief Act of 2007" (HR 1876) would amend the tax code to exempt debt forgiveness on principal home mortgages from being treated as income. The legislation would also help another class of troubled borrowers who negotiate pre-foreclosure "short sales" or deeds in lieu of foreclosure, or whose foreclosure proceeds are insufficient to pay off their mortgage debt.
If you think you're running into this kind of trouble, it is important to speak with a certified financial planner or a certified public accountant not only to estimate your tax risk but also to find out if there might be other approaches to your individual situation. It is not wise to count on any guaranteed break from Congress, particularly since the bill is in the early stages.