H. R. 3648, or the "Mortgage Forgiveness Debt Relief Act of 2007", is being presented as a "savior" of sorts for homeowners facing foreclosure. However, this may not be the case for many of those facing foreclosure in the Santa Clarita area.

Current IRS rules treat the difference between what is owed on the mortgage and the market value of the home, whether it is sold at auction, as a short sale (preforeclosure) or when relisted as a bank-owned property, as taxable income. The lender will issue a 1099-C to the homeowner for this amount, which must then be treated as ordinary income on the homeowner's next tax return. In most cases, the sale price of the home will be considered to be the market value, but this is always the true value. In some cases, the market value of the home will be reported as a higher amount than the actual sales price.

So if your home sells for $500,000 and you owe $600,000, you'll have $100,000 of additional income to report on your next tax return under current IRS rules. That would equate to a whopping $28,000 income tax bill if you're in the 28% tax bracket.

Many are hoping that the proposed "Mortgage Forgiveness Debt Relief Act of 2007", or H.R. 3648, will provide relief from this tax. However, if approved as currently stated, the relief will only be for homeowners who meet certain requirements. H.R. 3648 is meant for principal residences (not second homes or investment properties) and also only applies to the initial mortgages, not refi's. H.R. 3648 defines Qualified Principal Residence Indebtedness (or debt relief to be excluded from income tax) as follows: "For purposes of this section, the term 'qualified principal residence indebtedness' means acquisition indebtedness." In plain English, acquisition indebtedness is limited to the initial mortgage on the property when it was purchased, not a second (or third) mortgage that was acquired later, and not a refinance of the initial mortgage(s).

Most of the media hype lately has been focused on "predatory lending" issues, or "toxic loans" that sub-prime borrowers used to qualify the purchase of a home. The "toxic loan" situation where buyers qualifed for a home loan where there was either an introductory interest rate that escalated later, or a that had negative amortization (where the principal balance increases each month) is really only a small part of the foreclosure picture.

In the Santa Clarita area, the people walking away from their homes are quite often those who refinanced after the initial purchase for amounts in excess of their home's value when the market was still hot. Who knows what they bought with these funds, whether it was cars, boats or other toys, vacations, medical expenses, college tuition or whatever... The reality is that these people cannot sell for the total amount of their current mortgage, nor can they afford to continue paying the monthly tab for these loans.

More and more we're hearing people say that they'll just walk away and take the hit on their credit report for the next few years or so, and then they'll pick up the pieces and buy a home again later on. They feel that whatever they borrowed (and spent) is the bank's problem, and that they can walk away free and clear with no worries. So they live rent-free for the 6 months or so that it takes for the bank to foreclose and throw them out, while the rest of us continue to pay our mortgages and other bills like usual. Is it any surprise then that many people are up in arms over these new "mortgage forgiveness" programs?

There's really no free ride when it comes to foreclosures, especially when the mortgage is the result of a refi. Be sure to talk with a qualified Realtor about your options before you walk away from your home. It can be quite a shock to receive a huge tax bill from the IRS, especially when that tax bill could have been avoided. For more info on how the IRS treats home foreclosure and debt cancellation, click here.

Confused about your foreclosure or short sale options? Call Linda Slocum at 661.670.0349 or email her at Linda@SantaClaritaRealEstateBlog.com.