Faisal Shahzad's Tax Problem

Faisal Shahzad, the attempted Times Square bomber, purchased his home at 119 Long Hill Avenue, Shelton, CT in July 2004 for $273,000 -- he put down 20% ($54,600) and took out a conventional 30-year mortgage loan from Chase for $218,400.  In February 2009, he took out a $65,000 equity line of credit from Wachovia. In September 2009, Chase filed for foreclosure in Connecticut state court, reporting an unpaid balance on the first mortgage loan of $200,000.   (For details, see CNN, New York Times, Wall Street Journal, Washington Post.)

The Weekend Wall Street Journal explains the tax consequences of folks like Shahzad with their homes in foreclosure in A Surprise Tax Hit on Foreclosures: For People Who Lose or Walk Away From Their Homes, A Big Tax Bill May Loom, by Jeff D. Opdyke:

As the U.S. economy continues struggling with the fallout of the debt-induced housing crisis, millions of homeowners ... are discovering that their decision to walk away from a mortgage could result in tax bills running into the thousands or tens of thousands of dollars.

The upshot: anyone weighing whether or not to seek a mortgage modification—or debating whether to abandon a house that is worth less than the mortgage—should consider the tax treatment carefully before making a move. The same holds for any form of consumer debt that a bank ultimately cancels, including credit-card balances or an auto lease.

Federal and state tax laws have long viewed canceled debt as income because consumers who borrow money to buy a house—or who pull money out of their house to buy cars and such—and then don't pay it back "wind up ahead of where they were," says an IRS spokesman. ...

Overall, the IRS estimates that individual taxpayers will have filed nearly 3.6 million tax returns for 2009 that include income from canceled debt. That's down a bit from 2008, but up 17% from 2007. The numbers include taxes due on primary homes, vacation and rental property, credit cards, auto leases and other canceled debts. The IRS projects the numbers to rise in coming years.

Part of that rise will likely come as the government expands its mortgage-modification program, including a call in March by the Obama administration for banks to reduce principal as a way to help people remain in their homes. That reduction could lead to tax obligations.

At first the government's mortgage-modification program focused on primary mortgages, which are tied to the purchase or construction of a primary residence, and which are eligible for exemption under a 2007 Congressional act aimed at helping homeowners avoid the tax implications of a foreclosure. That act—the 2007 Mortgage Forgiveness Debt Relief Act—exempts taxpayers from as much as $2 million in forgiven debt. But the debt had to be acquired before Jan. 1, 2009—and had to have been used solely to buy, build or remodel/repair a primary residence.

The government's new, expanded modification programs include short sales, in which a bank agrees to accept as full payment less than the value of the mortgage balance; deed-in-lieu transactions, when a homeowner gives the house to the bank instead of repaying the mortgage; and second mortgages such as home-equity lines of credit. In many of those instances, say Treasury officials, homeowners used mortgage money to fund everything from tuition and medical bills to vacations and cars and even the down payment on a second home or investment property. That debt, however, isn't eligible for exemption. ...

Some homeowners can avoid the taxes completely if they can prove insolvency, in which the total value of debt exceeds total assets. But even that could leave some owing taxes. IRS rules stipulate that a taxpayer can escape taxes up to the extent of insolvency, meaning that if one's liabilities are $500,000 and assets are $300,000, the $200,000 difference is the extent of the insolvency. But if the person has $250,000 in debt canceled, then $50,000 is taxable income.