The Mortgage Forgiveness Debt Relief Act is set to expire on December 31, 2012 and has large implications for Nevadans.  Nevada is perennially in the lead, or in the top five in the U.S., in mortgage foreclosures.  When a house is foreclosed upon, the difference in debt owed less the value of the house sold at auction, is considered cancellation of debt income to the IRS. 

This is taxed at the taxpayer’s ordinary income rates with the cancellation of debt income putting the taxpayer in a higher income tax rate bracket.  With the proliferation of foreclosures and short sales starting in 2007, Congress passed The Mortgage Forgiveness Act which allowed this cancellation of debt to be excludable from income if it is from your personal residence.

But with this law expiring at the end of this year, Nevadans better be careful.  If you stop paying your mortgage now and don’t enter into a short sale, it is likely that the actual foreclosure will be put off into 2013 and that means the debts cancelled will be income. If you are $100,000 underwater this could create a tax liability of at least $25,000!

If you currently own one of the 67% of homes in Nevada that is underwater, according to the website Zillow, and are assessing your options be careful. Make sure that your home is sold at auction before December 31 or enter into a short sale to get the cancellation of debt into 2012. Another possible exclusion of cancellation of debt could also be of help to you beyond 2012. If you are insolvent immediately before the cancellation of debt, this will still be excluded from income.