Don't Mess With Taxes

As details emerged about Faisal Shahzad, the man who allegedly tried to set off a car bomb on May 1 in Times Square, much was made of the fact that, for a while, he lived a typical American lifestyle.

Sadly, that nowadays means that he encountered trouble holding onto his home.

Before Shahzad made his inept attack on New York City, he apparently walked away from the mortgage on his Connecticut house.

Defaulting on those payments seems like the least of Shahzad's worries right now, but TaxProf points out that the accused bomber also is likely to face a tax bill in connection with his former residence.

Records show that in 2004, Shahzad made a 20 percent down payment on a Shelton, Ct., residence and got a nice 4 percent interest rate on a conventional 30-year mortgage from Chase. So far so good.

Five years later, following his marriage and starting a family, he was able to cash in on the property via a $65,000 equity line of credit from Wachovia, which is now Wells Fargo. Shahzad and his wife no doubt had quite a few child-related expenses. And who among us homeowners hasn't tried to leverage our property for a little bit of extra cash?

But just a few months later, Chase initiated foreclosure proceedings in connection with the the original mortgage loan.

Why? In large part because the Shahzads reportedly quit making those monthly payments. In fact, they apparently abandoned the property in a hurry, judging by the stuff reportedly left behind.

Things went quickly downhill for homeowner Shahzad.

"The interest meter on his Shelton home kept ticking," notes CNNMoney.com. "And, as many American homeowners now understand far too well, home prices kept falling."

When the house was reappraised in mid-March, it was declared to be worth just $240,000 or 12 percent less than Shahzad paid for it six years ago.

Forgiving some mortgage debt taxes: There have been a variety of federal efforts during the housing bust to help out homeowners in similar situations. The most notable was the exemption from tax of certain income related to foreclosures.

As I wrote in Foreclosure tax double whammy eased:

Under prior law, when a home's value decreased and the lender and borrower negotiated a reduction in loan principal, the difference between the original and new debt was taxable income. A homeowner also could face similar tax liability when the lender completed a foreclosure and sold the home for less than the outstanding mortgage.

Officially, it is known as cancellation of debt, or COD income. It also is sometimes called discharge of indebtedness income or debt forgiveness. Regardless of the name, it produced a homeowner tax bill, generally calculated at ordinary rates ranging from 10 percent to 35 percent, depending upon the homeowner's income.

What the previous tax law essentially did was treat the foreclosure as a sale by the debtor, the owner of the property, with the proceeds being paid to the lender. Now, however, some homeowners who renegotiate their mortgages by Dec. 31, 2012, will not face any taxes on debt forgiven in the process.

So why is Shahzad possibly facing a tax bill in connection with the foreclosure on his home?

It's that home equity line of credit.

The law specifically prohibits homeowners who took advantage of the run-up in real estate prices to refinance their mortgages from getting the COD break. The only portion of a forgiven loan that can be free of tax is that amount used to improve the home. 

Extra insurance for prosecutors: Again, any potential tax bill is way down on Shahzad's worry list right now.

But for all you folks concerned that an alleged terrorist might be able to find a way to beat the rap, rest easier.

As with Al Capone, if Uncle Sam can't make the criminal case, the IRS is there to backstop the prosecution!

• Foreclosure's costly tax implications
• Foreclosure's other tax cost
• Second-home sellers to pay for foreclosure tax problems
• Trading credit card debt for a tax bill

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