The copywriter who thought up “Cash for Keys” did a good job. Unfortunately, the process isn’t as simple as the catchy title implies. You don’t simply hand the keys over to the mortgage company, take your $1000 to put down on an apartment and walk away.
The tax authorities treat forgiven debt as income and tax it at ordinary income rates. Sell a piece of real estate for $800,000 on which you owe $900,000, and the bank forgives the debt, you have income of $100,000 and potential tax liability of $38,000. Remember that the debt to the bank would be dischargeable in a bankruptcy; however, the debt to the taxing authorities is not dischargeable.
It is my understanding that the taxpayer has the burden of proving the any shortfall was related to the purchase of the property or improvement of the property. This, in itself, could be difficult because of dealing with the IRS.
Whether debt forgiveness income is triggered is a legal and accounting question that depends completely on the facts of the case.
If you’re having trouble making your mortgage payments, chances are you have other financial difficulties. Don’t take a piecemeal approach to solving them. Consult with a qualified advisor who can evaluate the best approach for you.
Tamela: Deeds in lieu are similar to short sales in that a wide variety of facts must be considered in order to make a decision about the legal, tax and credit consequences. Facts to be considered include
(1) the original documents related to the mortgage and the documents relating to the deed in lieu (typically, both drafted by the lender),
(2) the character of the real estate securing the mortgage (primary residence or investment property),
(3) in what state the property is located, and what exemptions the borrower can claim, and
(4) the borrower’s overall financial circumstances.
As with short sales, 90%+ of our clients have other debts in addition to the mortgage debt at issue in a deed in lieu/cash for keys offer. For these people, a deed in lieu is at best a Bandaid (when a tourniquet would be more appropriate) that will not resolve their overall financial picture and may well make it worse.
The Reuters article you linked to below is disingenuous in that it uses “fresh start” language (only a bankruptcy can give a true fresh start) and further implies that a deed in lieu will not negatively affect the borrower’s credit. Deeds in lieu are a matter of public record and will be picked up by the credit bureaus, and result in a serious hit to the borrower’s credit score; as much as a 250 point drop, from what I read.