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One of the "must-pass" provisions needed to make the Treasury Department's recently announced sub-prime mortgage relief plan work was an exclusion of mortgage debt forgiveness from a homeowner's income. Otherwise, beleaguered homeowners would also become saddled with unmanageable income tax debt. The centerpiece of the Mortgage Forgiveness Debt Relief Act of 2007 is a three-year exception for debt forgiveness on qualified home loans.
In addition, a handful of other real estate-related benefits found their way into the new law. These include a significantly expanded time-period for a surviving spouse to use the higher home sale exclusion, a three-year extension of the mortgage insurance premium deduction, the exclusion from income of certain state and local tax breaks given to firefighters and emergency medical technicians, clarification of student housing eligible for the low-income housing credit, and a more liberal qualification test for cooperative housing corporations.
The cost of the measure is being paid for by tax and fee increases on businesses.
Foreclosure Relief
When a lender forecloses on property, sells the home for less than the borrower's outstanding mortgage and forgives all or part of the unpaid mortgage debt, the Tax Code normally would consider the cancelled debt to be taxable income to the homeowner. The Mortgage Forgiveness Debt Relief Act of 2007
excludes from taxation discharges of up to $2 million of indebtedness that is secured by a principal residence and is incurred in the acquisition, construction or substantial improvement of the principal residence. This special relief is available for three years beginning January 1, 2007, and ending December 31, 2009. Relief is expected to total more than $600 million, which represents direct
cost savings to homeowners.
Example. Adam's principal residence is subject to a $220,000 mortgage debt. Adam's creditor forecloses in 2008. Due to declining real estate values, the residence is sold for $180,000 later that year. Adam has $40,000
discharge of indebtedness income. Before the new law, the $40,000 would have been includible in Adam's gross income.
The new provision is retroactive to January 1, 2007, to help as many homeowners as possible. However, homeowners who have already reported indebtedness discharge income on their 2006 returns will face an almost impossible task trying to argue that the debt was not really forgiven until 2007 due to a continuing personal liability on the mortgage note. The general rule is that a debt is cancelled or forgiven when, considering all the facts and circumstances, an identifiable event occurs that makes it likely that the debt will never be paid.
Mortgage workouts. Mortgage renegotiations are included in the law's new exception in addition to covering foreclosure situations. When a lender determines that foreclosure is not in its best interest (since the typical foreclosure nets the lender only about 60 cents on the dollar), it may offer a mortgage workout under which the terms of the mortgage are changed to result in a lower monthly payment.
One workout plan organized by the Bush Administration and a group of lenders would forego adjustable rate resets for up to five years. This and other mortgage workouts technically would result in forgiveness of indebtedness income that would be taxable to the homeowner if it were not for the new law.
Indebtedness. The new law applies to qualified principal residence indebtedness which means acquisition indebtedness. This is indebtedness that is generally incurred in the acquisition, construction or substantial improvement of the principal residence of the taxpayer and is secured by the residence. It also includes refinancing of such debt to the extent that refinancing does not exceed the amount of the original indebtedness.
Unlike the current deduction for qualified residence interest that includes interest on $1 million in acquisition indebtedness plus $100,000 of home-equity debt, the new mortgage debt exclusion includes $2 million in acquisition indebtedness but counts no home-equity debt not used for renovation.
Homeowners who took advantage of the run up in real estate prices to do "cash-out" refinancing, in which the funds were not put back into the home but, instead, were used to pay off credit card debt, tuition, medical expenses, or other expenditures, are not covered by the new law exclusion for the cash-out amount. That indebtedness income is fully taxable income unless other exceptions such as insolvency or bankruptcy can be met.
Principal residence. A taxpayer's principal residence for purposes of the new law is the same as that under the home sale gain exclusion. A principal residence is generally the one in which the taxpayer lives most of the time. However, the determination of a taxpayer's principal residence is based on "all the facts and circumstances."
The new law's debt forgiveness income exclusion does not apply to vacation homes or other second residences which a taxpayer may have overextended family finances to purchase.
Basis. The basis of the taxpayer's principal residence is reduced by the amount excluded from income under the new law. This will nevertheless result in complete tax forgiveness for most taxpayers since the $250,000 gain excluded on the sale of a principal residence ($500,000 for married couples filing jointly) generally covers most gain.
While the home sale exclusion may not cover all gain, the price for not recognizing immediate ordinary income for debt forgiveness in mortgage workouts is deferred home sale gain taxed at capital gains rates - not a bad trade.
The new law denies the exclusion if the loan is discharged because of services performed for the lender. The exclusion also does not apply to taxpayers in Chapter 11 bankruptcy.
Mortgage Insurance Deduction
The Tax Relief and Health Care Act of 2006 temporarily allowed taxpayers to take an itemized deduction for premiums paid or accrued on qualified mortgage insurance as deductible qualified residence interest. To be deductible, the premiums must be paid or accrued for qualified mortgage insurance obtained in connection with acquisition indebtedness on a qualified residence.
The deduction is phased out at 10 percent for each $1,000 by which the taxpayer's AGI exceeds $100,000. The Mortgage Forgiveness Debt Relief Act of 2007 temporarily extends the deduction for qualified mortgage insurance premiums for three years, through December 31, 2010. The new law extends the mortgage insurance deduction to amounts paid or accrued after December 31, 2007, but only with respect to contracts entered into after December 31, 2006, or prior to January 1, 2011.
Qualified mortgage insurance is mortgage insurance provided by the Veterans Administration, the Federal Housing Administration, the Rural Housing Administration, or private mortgage insurance (as defined in Section 2 of the Homeowners Protection Act of 1998).
The new law does not allow a deduction for the unamortized balance of mortgage insurance premiums that have been capitalized if the mortgage debt is satisfied prior to the end of its term.
Survivor's Home Sale Exclusion
In an important development for recently-widowed spouses, the new law extends the period of time during which a surviving spouse may use the joint- return filers' $500,000 home sale gain exclusion before being treated as a single individual entitled only to a $250,000 exclusion. Previously, a surviving spouse was entitled to the $500,000 exclusion only to the extent he or she could file a joint return with the deceased spouse's estate, which only occurs for the tax year in which the spouse dies.
Starting January 1, 2008, the sale of a residence that had been jointly owned and occupied by the surviving and deceased spouse is entitled to the $500,000 gain exclusion provided the sale occurs no later than two years after the date of death of the individual's spouse.
The surviving spouse in the case of a jointly owned residence continues to be allowed a step up in basis in the residence for the deceased spouse's one-half
share. The $500,000 exclusion is in addition to that benefit.
Volunteer Emergency Responders
The foreclosure relief bill also gives volunteer firefighters and emergency medical responders some tax relief. Individuals who receive a qualified state and local tax benefit, any reduction or rebate of a tax and qualified payments of up to $360 each year provided on account of their volunteer services, can exclude them from income. This treatment applies to tax years beginning after December
31, 2007.
Offsets
The cost of foreclosure relief and the other tax benefits are offset by several revenue raisers:
- An increase in the failure-to-file penalty for partnerships from $50 to $85 per partner per month, up to 12 months (effective as of the date of enactment)
- A new failure-to-file penalty for S corporations of $85 per S shareholder per month, up to 12 months
- Increases in corporate estimated tax payments for corporations with $1 billion-plus assets, by 1.5 percent to 117.25 percent for payments due in July, August and September 2012.
Posted January 3, 2008.
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