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Tax relief on forgiven debt hangs off of fiscal cliff

The rhetoric around the fiscal cliff and the federal budget negotiations has gotten quite heated in recent weeks, as lawmakers from both sides of the aisle try to find a way to balance the budget. Regardless of one's political party, most Florida readers know that much of the negotiation being done is around the tax code. Many lawmakers are pushing to simplify the tax code, but there are differing opinions about the best way to do that.

One of the big issues up for discussion is which tax breaks to keep and which should expire. One tax break with an uncertain future is the Mortgage Forgiveness Debt Relief Act, which relieves homeowners who have gone through a foreclosure, short sale, or mortgage modification from paying taxes on the forgiven debt as though it were income. The Act become law in 2007 when the housing crisis was at its worst and homeowners across the country couldn't afford the high tax bill that accompanied debt relief.

Since those who seek debt relief under a foreclosure, loan modification, or a short sale have typically taken on debt that far surpasses their income level, taxing the forgiveness as income has a major effect on their tax bracket. Imagine making $40,000 a year and suddenly paying income taxes for a foreclosure on a $100,000 in mortgage debt. That increases a normal middle class earner's tax liability to be commensurate with some of the highest earners in the country. Experts say some homeowners could wind up facing tax bills of $25,000 or more if the tax break expires.

Aside from declaring bankruptcy, Florida residents can try to avoid the high tax bill by showing the IRS that at the time the debt was forgiven, they had more debt than assets. This means proving that they are legally insolvent and getting a confirmation on that from the IRS, which can be a difficult task. However, the IRS is often more willing to work with taxpayers than many Florida residents realize. Most experts would agree that failing to act is the worst case scenario, since borrowers with forgiven debt could wind up with a new creditor - the IRS.

Source: The Sun-Sentinel, "No action yet on relief act," Paul Owers, Dec. 26, 2012.

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