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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.
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Small Business Tax News
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.
Mortgage Forgiveness Debt Relief Act of 2007
In December 2007, President Bush signed legislation that provided limited tax relief for borrowers whose home mortgage debt is forgiven. The Mortgage Forgiveness Debt Relief Act of 2007 is intended to protect homeowners whose mortgage debt is restructured or forgiven as a result of a foreclosure. But the relief provided by the act, is very limited and applies 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 second 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 relief, based on insolvency, for example, may be available. The law limits qualified principal residence 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 eliminated 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 carefully. 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). 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 taxpayer had personal liability. The lender foreclosed and the home was sold for $180,000 in satisfaction 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 result 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.
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 borrowers. Some 51 percent of option ARM borrowers 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 forgiveness law. For example, if a borrower’s second lien is $50,000 and he gets a modification using 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.
“Qualified principal residence indebtedness also includes any debt secured by your principal residence resulting from the refinancing of debt incurred to acquire, construct, or substantially improve your principal residence 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 principal 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 indebtedness 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
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