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Richmond, California's Eminent Domain Move has Tax Consequences That Could Derail the Plan

In early August, Richmond, California decided to use a highly controversial method to aid homeowners who are underwater on their mortgages: eminent domain. Eminent domain, a power reserved to the federal government in the Fifth Amendment, is the taking of property by the government for "public use" with just compensation for the one whose property is taken. The federal government has allowed states to use eminent domain and those states in turn have allowed their municipalities and counties to wield the power as well.

Richmond plans to take the mortgages of 600 homeowners via eminent domain and reduce their principle balance so as to reduce the risk of default. But a problem has been foreseen by some that could cause the plan to be moot: taxes. Under federal income tax laws, when a loan is disbursed to a borrower (in this case, a mortgage), the funds are not considered income even if they might behave as such because they will eventually be repaid. However, if a lender chooses to forgive a portion of the debt, or cancels/reduces the debt, it is then considered income and the borrower incurs a tax liability. There are a few exceptions to this tax liability, but by and large, the borrower will owe taxes on the cancelled portion of the loan.

Fortunately, there have been exemptions in place for homeowners that were supposed to expire at the end of 2012, but have been extended through the end of this year and are likely to be extended again. Banks and other real estate entities are fighting this attempt by the city of Richmond and have created a quagmire of lawsuits that could take some time. Whether the extensions on the homeowner exemptions will continue through these lawsuits is uncertain.

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