Homeowners facing foreclosure in California have approximately 120 days from the Notice of Default (about 4 months) in order to resolve their outstanding mortgage debt. When a homeowner finds themselves in this situation, the most proactive step a homeowner can do is to act in a timely manner to get a realistic look at what their options may be. There are many choices that a homeowner can choose from in order to best reduce the overall loss during the stressful financial situation they may find themselves in; however, denial shouldn't be one of them.

In the slew of options that are available, there is a little-known transaction known as a "short sale" which to some homeowners in foreclosure may seem like a dream come true. Short sales occur when a lender allows a homeowner in default to sell a house for less than the total value of the loan. In many cases, the lender then forgives the remaining portion of the debt. But before a homeowner who finds himself in foreclosure gets too excited about what seems like welcome debt relief' there is a catch.

So what's the catch? Lenders may claim whatever debt they've forgiven as a loss on their taxes and issue a 1099 form to the homeowner; in this case the seller, for the total amount. In other words, the forgiven debt is taxed as earned income and depending on the loss and the homeowner's (and potential seller's) tax bracket it could mean a significant increase in their taxes.

A homeowner should definitely check with his accountant for this information. On the other hand, if a property is sold under a short sale, the lender may require the buyer to make up the difference, either through a personal obligation or a collection for the remaining balance often referred to as a deficiency judgment. According to Barron's banking dictionary, the definition officially is "Court order authorizing a lender to collect part of an outstanding debt from foreclosure and sale of the borrower's mortgaged property or repossession of property securing a debt, after a finding that the property is worth less than the book value of the outstanding debt."

However, while it has typically been a lender's practice to issue a 1099 form to the homeowner for the total amount forgiven, it is also true that every rule has its exception.

Reporting in the Santa Cruz Sentinel (Mar 2007) regarding foreclosures in the Santa Cruz area, the reporter referred to a bill that is currently being reviewed by the house Ways and Means Committee in Washington D.C. If passed, this bill will bring welcome tax relief to those homeowners who are currently in foreclosure.

To give borrowers who are over their heads a break, Rep. Robert Andrews, D- N.J., and Rep. Ron Lewis, R-Ky., proposed HR 1876 in April. If the Mortgage Cancellation Relief Act of 2007 is passed and signed by the president, borrowers would not have to pay income taxes when their lender forgives part of their mortgage in a short sale or in a foreclosure.
Current law treats the cancellation of any debt as taxable, even though the borrower experiences a loss and receives no cash. The bill is being reviewed by the House Ways and Means Committee.

So, it would follow that a homeowner should check with their tax accountant to see if any modifications have been made regarding this law and then, he or she can make an informed decision in pursuing a short sale. With the increase of foreclosures, it may be that this bill may pass and give the proposed 'welcome relief' to the many distressed homeowners in foreclosure.

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