Mortgage Forgiveness Debt Relief Act of 2007

Earlier this week I had a conversation with an accountant who was asking me about people who were selling their houses in short sales. We discussed the increase of this in the St. Louis area and he suggested that he put together some information that my clients might find helpful regarding the Mortgage Forgiveness Debt Relief Act of 2007. Here is the letter in its entirety.

August 15, 2008

Dear friend:

With the economy in its current challenged state, coupled with the real estate market and its issues, there has been a lot of activity regarding foreclosures, short sales, and debt restructuring. I continue to get a lot of questions regarding the tax consequences for home owners in these situations. The rules have changed in this area. Under the old rules, forgiveness of debt could trigger taxable income for the person being relieved of debt. The new rules drastically help taxpayers needing forgiveness of debt associated with their primary residences, but it only applies to debts discharged from January 1, 2007 to December 31, 2009. With the Mortgage Forgiveness Debt Relief Act of 2007, a taxpayer does not have to pay federal income tax on up to $2 million of debt forgiven for a loan secured by a qualified principal residence. More details are highlighted below.

Discharge of indebtedness income: background

For income tax purposes, a discharge of indebtedness (“forgiveness of debt”) is generally treated as taxable income. However, a discharge of indebtedness doesn’t trigger gross income if it: (1) occurs in a Title 11 bankruptcy case, (2) occurs when the taxpayer is insolvent, (3) is a discharge of qualified farm indebtedness, or (4) is a discharge of qualified real property business indebtedness.

Before the 2007 Mortgage Relief Act, there were no special rules applicable to discharges of acquisition debt on the taxpayer’s principal residence. For example, assume a taxpayer who isn’t in bankruptcy and isn’t insolvent owns a principal residence subject to a $200,000 mortgage debt for which the taxpayer has personal liability. The creditor forecloses and the home is sold for $180,000 in satisfaction of the debt. Under old rules, the debtor had $20,000 of debt discharge income.

Current law relief provision

The 2007 Mortgage Relief Act excludes from a taxpayer’s gross income any discharge of indebtedness income by reason of a discharge (in whole or in part) of qualified principal residence indebtedness before January 1, 2010. The exclusion applies where taxpayers restructure their acquisition debt on a principal residence or lose their principal residence in a foreclosure.

Here is some of the critical fine print in this new relief provision:

• The tax relief applies to the original purchase price, plus improvements, of the taxpayer’s principal residence. It doesn’t apply to discharges of second mortgages or home equity loans unless the loan proceeds were used to acquire, construct, or substantially improve the taxpayer’s principal residence. Refinanced indebtedness qualifies only to the extent it does not exceed the amount of indebtedness being refinanced. (Cash out from refinancing will not qualify for the exclusion.)

• The indebtedness must be incurred specifically in respect to the taxpayer’s principal residence. The exclusion rule does not apply to second homes, vacation homes, business property, or investment property since these properties are not the taxpayer’s principal residence.

• The relief provision is not a permanent fixture of the tax code. It only applies to forgiveness during 2007, 2008, or 2009.

• Nontaxable forgiven mortgage debt is capped at $2 million ($1 million for married individuals filing separately).

• When the relief provision applies, the tax basis of the individual’s principal residence is reduced by the amount excluded from income. As a result of this basis reduction rule, the discharged indebtedness is technically subject to taxation at a later time. However, in many cases the reduction will not result in any additional tax because any gain on that sale or exchange will qualify for the $250,000 ($500,000 for married couples filing jointly) home-sale exclusion.
  

Please keep in mind that this is only a summary of this important tax relief provision. If you would like more details about this change, or any other aspect of the new law, please do not hesitate to call. Keep in mind that every taxpayer’s situation is different and should be analyzed with his or her tax advisor and counsel to determine what applies for the given circumstances.

Best regards,

HOFFMAN CLARK, LLC

Bryan Shaw, CPA

www.hoffmanclark.com