Taxes on Mortgage
Small Business
Debt Forgiveness
Dear Real Estate Agents,
In today’s economy we all need every advantage to gain new
business. We here at Inside Mortgage Finance are glad to offer
you this free white paper on a very timely issue: Mortgage debt
forgiveness.
This white paper comes from the editors of our publication,
Small Business Tax News, a monthly resource—a newsletter that
also provides “tax briefs” like this for independent contractors and
small business people across the country. We hope it helps you win
over more homebuyers.
Mortgage Forgiveness Debt Relief Act of 2007
In December 2007, President Bush signed legislation that
provided limited tax relief for borrowers whose home mort-
gage debt is forgiven. The Mortgage Forgiveness Debt Relief
Act of 2007 is intended to protect homeowners whose mort-
gage debt is restructured or forgiven as a result of a foreclo-
sure. But the relief provided by the act, is very limited and ap-
plies only to loans used to acquire, construct or substantially
improve a principal residence.
Debt used to refinance qualifying debt is also eligible for
the exclusion, but only up to the amount of the old mortgage
principal, just before the refinancing. Debt forgiven on sec-
ond homes, rental property, business property, credit cards or
car loans does not qualify for the new tax-relief provision.
In some cases, however, other kinds of tax re-
lief, based on insolvency, for example, may be
available.
The law limits qualified principal resi-
dence indebtedness to an aggregate
amount of $2 million ($1 million in
the case of a married individual filing a
separate return).
Borrowers whose debt is reduced or elimi-
nated receive a year-end statement (Form
1099-C) from their lender. For debt cancelled
in 2007, the lender was required to provide
this form to the borrower by Jan. 31, 2008.
By law, this form must show the amount of
debt forgiven and the fair market value of any property given
up through foreclosure.
The IRS urges borrowers to check the Form 1099-C care-
fully. Notify the lender immediately if any of the information
shown is incorrect. Borrowers should pay particular attention
to the amount of debt forgiven (Box 2) and the value listed for
their home (Box 7).
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Tax News
Introduction
The economic downturn left hundreds of
thousands of homeowners underwater,
and current efforts to minimize losses
include measures that forgive portions
of the outstanding mortgage debt. A law
passed in 2007 makes debt forgiven on
primary mortgages exempt from federal
taxable earnings, but the law omitted
some mortgages.
The Emergency Economic Stability Act enacted in October
2008 extended this relief through 2012. Thus this relief now
applies to debt forgiven in calendar years 2007 through 2012.
Before the law was passed, gross income included income
from the discharge of indebtedness. Gross income does not
generally include proceeds from a borrowing because the
proceeds are offset by the liability to repay. The removal of
that liability, however, left the borrower with a net increase in
wealth, and is thus available for taxation. The rule requiring
discharges of indebtedness to be included in income is subject
to certain exceptions, such as discharges occurring in title 11
bankruptcy cases or when the debtor is insolvent. When such
an exception applies, the taxpayer is generally required to
reduce certain tax attributes, including basis in property,
by the amount of the discharge of indebtedness, so
that the benefit of the discharge can be captured
in income later.
For example, assume a taxpayer
who wasn’t in bankruptcy and
wasn’t insolvent owned a principal
residence subject to a $200,000
mortgage debt for which the tax-
payer had personal liability. The
lender foreclosed and the home
was sold for $180,000 in satisfac-
tion of the debt. Under pre-2007 tax
law, the debtor had $20,000 of debt
discharge income. The result was the
same if the lender restructured the loan
and reduced the principal amount to $180,000. But with
the MFDRA, the borrower has no debt discharge income
when the lender restructures the loan and reduces the
principal amount to $180,000 or forecloses with the re-
sult that the $200,000 debt is satisfied for $180,000.
Unprotected Forgiven Debt
The law “may not provide relief to the large number of borrowers who took cash out in refinancings or
who borrowed on home-equity lines if the cash was not put back into the borrower’s home,” noted Roger
Wise, a partner in the Washington, DC, office of law firm K&L Gates.
Subordinate Liens
A 2009 report from Amherst Securities Group
noted that 58 percent of prime borrowers whose
loans are pooled in securities not guaranteed by
Fannie Mae, Freddie Mac or Ginnie Mae have
second liens, along with 56 percent of Alt A bor-
rowers. Some 51 percent of option ARM bor-
rowers in non-agency MBS have second liens
along with 38 percent of subprime borrowers.
These second liens would be subject to taxes, as
they don’t fall within the scope of the debt for-
giveness law.
For example, if a borrower’s second lien
is $50,000 and he gets a modification us-
ing principal forgiveness on his first lien, he
would still owe – assuming a 28 percent tax
bracket – $14,000 in taxes, as his second
lien is not protected.
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Refinances
“Qualified principal residence indebtedness also includes any debt se-
cured by your principal residence resulting from the refinancing of debt
incurred to acquire, construct, or substantially improve your principal resi-
dence but only to the extent the amount of debt does not exceed the amount
of the refinanced debt,” the IRS said in Publication 4681.
For example, in 2002 Becky purchased a principal residence for
$315,000. Becky took out a $300,000 mortgage loan to buy the prin-
cipal residence and made a down payment of $15,000. The loan
was secured by the principal residence. In 2003, Becky took out a
second mortgage loan in the amount of $50,000 that she used to add
a garage to her home.
In 2008, when the outstanding principal of her first and second
mortgage loans was $325,000, Becky refinanced the two loans into
one loan in the amount of $400,000. The fair market value of the
principal residence at the time of the refinancing was $430,000.
Becky used the additional $75,000 ($400,000 new mortgage loan
minus $325,000 outstanding principal balance of Becky’s first and
second mortgage loans immediately before the refinancing) to pay
off personal credit cards and to pay college tuition for her daughter.
After the refinancing, Becky’s qualified principal residence indebt-
edness is $325,000, because the debt resulting from the refinancing
is qualified principal residence indebtedness only to the extent the
amount of debt does not exceed the amount of the refinanced debt.
If Becky were to be offered $100,000 in principal forgiveness as
part of a short sale agreement on her $400,000 house, she would
still have to pay taxes on the $75,000 of unqualified debt not covered
by the 2007 legislation.
If a lender forgives or writes off $600 or more of a debt’s principal, it
must send the borrower and the IRS a Form 1099-C at the end of the year.
When the borrower files his tax return for the tax year in which the debt
was written off, the IRS will require him to report the amount on the form
as income. There are several exceptions to this rule stated in the IRS Code.
For example, borrowers do not have to report the income on the tax return
if the write-off of the debt is intended as a gift, the debt is discharged in
bankruptcy, or the borrower was insolvent before the lender agreed to settle
or write-off the debt.
Sources:
IRS
IRS Publication 4681,
Cancelled Debts, Foreclosures,
Repossessions and Abandonments
K&L Gates
March 2010