A while back I wrote about how millions of homeowners are finding themselves underwater in their mortgage. In other words, they are finding that they owe more on their home than it is currently worth. It's frustrating to have to pay more on your home than you could get for it if you sold, and many are deciding that their best option might just be to strategically default on their mortgage. Why keep paying if your home isn't worth what you thought it was? Why throw good money after bad?
There is a heated debate as to whether strategically defaulting is OK to do morally, but plenty of people are accepting it as a viable alternative. For those that decide to go down that road, are they considering all the implications?
Tax Implications Of A Strategic Default
One thing a lot of people don't realize is that if you strategically default on your home mortgage, and the bank forecloses, you may be liable for the taxes on your forgiven debt.
In many states, any part of a mortgage that the bank forgives is reported as taxable income.
In some states, you’re off the tax hook if the bank forecloses on your original mortgage. But you could still be taxed on a home equity loan or a loan you refinanced.You’ve probably heard that the government has temporarily stopped taxing people who lose or give up their homes. That’s the Mortgage Forgiveness Debt Relief Act (otherwise known as “The Don’t Kick ‘Em When They’re Down Act”). But it doesn’t apply to every mortgage. You can be foreclosed and get a tax bill, too.
The majority of people going through foreclosure have no choice. They can’t afford the payments any more. But a growing number of homeowners are choosing “strategic default.” They’re not broke. They owe more than the house is worth and decide to stop throwing good money after bad. Many considerations come into the default decision — moral, reputational, financial, credit-score, and what the kids will think. Taxes matter, too
So if you default on your mortgage loan, even though you're able to pay the bank – and the bank forgives part of your loan, you could be getting a big tax bill.
You’re generally taxed on debt that a lender forgives. For example, say that you default on a $350,000 first-mortgage loan. The bank sells the property for $250,000. If the bank has the right to pursue you for the remaining $100,000 but doesn’t, that “forgiven” amount is taxed to you. States with these rules are called “recourse” states.
The Debt Relief law wipes out the taxes due, but only for certain types of loans.
In some states — called “non-recourse” states — a bank that forecloses generally does not have the right to chase you for additional money. As a result, the unpaid debt ($100,000, in this example) is not taxed as income. You get away scot free.
So which states are non-recourse states where you'll be off the hook for taxes?
Non-Recourse States: Alaska, Arizona, California, Connecticut, Florida, Idaho, Minnesota, North Carolina, North Dakota, Texas, Utah, Washington.
In other states you may be liable for taxes due if the bank forgives part of your principle balance after selling your property.
Other situations in which you won't be liable for taxes due include when you are bankrupt or insolvent.
Tax Forgiveness On Forgiven Debt Doesn't Cover All Loans
There is an asterisk on the tax free status for the non-recourse states. The tax free laws only cover three types of loans:
- The original mortgage from when you bought or built the home
- The balance of the original mortgage at the time you refinanced.
- A cash-out refinancing or home equity loan when the proceeds were used to improve the home.
If you borrowed against your home in order to pay off a credit card, or to buy a car for example, you will be liable for taxes on those amounts.
What do you think about the tax implications of strategically defaulting on your mortgage? Do you think most people consider that they may have to pay taxes on the forgiven amount of debt? Tell us your thoughts in the comments!