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On Dec. 20 President Bush signed into law the Mortgage Forgiveness Debt Relief Act of 2007. For three years, from Jan. 1, 2007, through Dec. 31, 2009, certain discharges of mortgage indebtedness on a principal residence can be excluded from a taxpayer's gross income.
Foreclosure rates have been increasing and many homeowners are reeling as subprime adjustable-rate mortgages suddenly become much more expensive. That and the fact that housing prices are falling all over the country makes many people feel so pressured that they are selling their homes for less than what they paid or are facing foreclosure.
Some taxpayers engage in so-called "short sales." Let's say you paid $200,000 for your house and got a 90 percent mortgage to purchase it. Your debt is $180,000.
Now, suppose your mortgage payment has gone up substantially, your income has gone down and you are unable to make the payments. Rather than waiting for the bank to foreclose, you sell the property.
Unfortunately, housing prices have plummeted, so you can get only $170,000 for the house. You contact your lender and the lender agrees to accept the $170,000 in full satisfaction of your $190,000 debt. The sale price was such that you were "short" the money needed to pay off the mortgage.
The general rule is that when a person is relieved of debt through either the forgiveness of the debt by the lender or though a bankruptcy proceeding, the amount of debt forgiven or discharged is taxable income to the debtor. The person is treated as if he or she received income in the amount of the debt that was used to pay off the debt.
Tax preparers call this forgiveness of indebtedness "income." While the taxpayer may have gotten out of debt, he now has to pay tax on the "income" — which may cause him to incur another debt.
The forgiven debt may qualify under the "insolvency" exclusion from taxable income. A taxpayer is not required to include forgiven debts in income to the extent that the taxpayer is insolvent.
In this context, insolvent means the taxpayer's total liabilities exceed his or her total assets. It is also possible the forgiven debt may qualify for exclusion from income if the debt was discharged in a Title 11 bankruptcy or a few other very limited circumstances.
In general, however, the debt forgiveness is taxable income to many of these taxpayers. These people are already in straightened financial circumstances.
They do not have money to pay additional income tax. The purpose of the Mortgage Forgiveness Debt Relief Act of 2007 is to allow homeowners to arrange lower debt payments without facing higher income taxes.
There are limitations:
1. The amount of debt forgiveness that qualifies for the exclusion from income is limited to $2 million.
2. The debt that is discharged or forgiven must be debt that was used to buy, build or substantially improve a home. If you refinanced, the debt is eligible but only up to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified. If you take out additional equity, that debt does not qualify for this exclusion.
3. Where your home is not sold but the debt is "restructured" and as part of that restructuring the loan balance is reduced, the debt forgiveness amount is not taxed as income; however, the amount of debt forgiveness reduces the borrower's basis in the property. Thus, it's possible there could be a subsequent capital gains tax on the forgiven amount.
4. The forgiveness provisions apply only where the debt forgiveness resulted from a decline in the value of the property or the financial condition of the borrower.
The amount of debt forgiven must be reported on IRS Form 982 and accompany your 1040.
E-mail: Patti@spencerlawfirm.com
