Homeowners getting out of home they can't afford could face tax hit

The last thing somebody who couldn't pay the mortgage would expect is a tax document in the mail that proclaims they magically got an extra $20,000 in income they never touched. But that's exactly the tortured tax picture that faces many troubled homeowners.

Thousands of families could face an unexpected tax hit if they went through foreclosure, worked out some unusual deals with the bank to refinance or sold homes for less than the outstanding debt.

Michigan Democratic U.S. Sen. Debbie Stabenow told me during a phone interview that she'd like to see this unfair tax rule change by year's end. On Aug. 31, President Bush gave his support to Stabenow's mortgage relief act as part of his package to assist homeowners.

It's one of those tax rules that not many people know about because home values typically have gone up, not down. But it could have a big impact on families nationally.

Say a homeowner loses a job, needs to move and has to sell the house for $80,000 instead of the $100,000 owed on the mortgage. If the bank forgives $20,000, as is possible in some cases, it has to be reported as income. For many families, an extra $20,000 could mean that they've got to pay an extra $3,000 to $5,000 or more in federal income taxes.

"The general rule is that cancellation of debt is taxable income," said Bob D. Scharin, RIA senior tax analyst at Thomson Tax & Accounting.

Or how about a homeowner who is able to pay the mortgage at the initial adjustable rate, but then the rate readjusts upward significantly, and suddenly the mortgage payment is unaffordable.

Say the homeowner would like to refinance. But there's a snag. Some homes now are being valued below the original mortgage taken out three, four or five years ago. So the house might be valued at $100,000 instead of $120,000. And the homeowner might not have enough equity in the house to deal with the difference.

If the bank steps in and refinances the house at $100,000 instead of $120,000, the homeowner would run up against that tax hit.

In some cases, consumers are able to avoid the added tax.

"The one big exception is bankruptcy," said James Jenkins, president of Jenkins & Co., a tax firm in Southfield, Mich. If the debt is discharged in bankruptcy, no tax.

Another option: Taxpayers could file a complicated tax form, Form 982, to show that they were insolvent.

"How's the average guy going to possibly know the rules on this?" Jenkins asked, noting that an experienced tax preparer could save some consumers money and avoid much of the tax.

Reach Susan Tompor at stompor@freepress.com.