Mortgage Forgiveness Act Provides Income Tax Relief To Foreclosed Homeowners

What’s positive about being foreclosed upon or selling your home for less than you owe?  Well, for most people, not much.  Yes, you are relieved of an onerous mortgage loan and you are now free to find housing that is more affordable within your budget.  But not everyone fully understands the lingering effects of a foreclosure as it pertains to the mortgage debt forgiveness.  This applies to foreclosures, short sales and a deed in lieu of foreclosure.

Foreclosure can be one of the most devastating things a homeowner can face.  At a minimum, they will end up with damaged credit.   Until recently, the tax laws further penalized homeowners who were relieved of mortgage debt obligations with additional taxation.  Homeowners owe taxes on the amount of the debt obligation from which they are relieved.  For example, let’s look at a short sale.  If a bank agreed to accept $200,000 as payment in full to satisfy a mortgage where the homeowner owed $250,000, the homeowner would owe taxes on $50,000.  They were relieved of repaying $50,000 in mortgage debt.  When you are relieved of debt, you are actually benefiting because you no longer have the obligation to pay it back.   Hence you must pay tax on this “unrealized income” even if there was no direct corresponding benefit, such as equity proceeds from a sale.  At the same time, how is the homeowner who just lost everything going to be able to pay tax on the differential of the satisfied mortgage obligation when they received no tangible proceeds from the sale? 

As we have just seen, the amount of debt forgiveness is considered income.  All debt forgiveness, not just mortgage debt, results in reportable taxable income.  Many people who’ve walked away from their homes have found this out the hard way.  Many found out at the end of the year when they opened their mail and found they’d received a 1099C.  The 1099C is the IRS form that the creditor gives the debtor when they have forgiveness of debt. 

Today we have a record number of foreclosures.  When banks and lenders sell homes they’ve gotten back during the foreclosure process they are less concerned about the bottom line and more concerned about being rid of the collateral.  This can result in spiraling downward values in areas or communities where foreclosures are high.  Large numbers of foreclosures like we are currently experiencing are hurting our overall real estate market valuations.

One solution to the problem has been to encourage those homeowners in distress to work with the bank to sell the home while they continue to occupy the property.  This may result in a short sale, whereby the bank agrees to accept less than is owed on the outstanding mortgage.  Together, the bank and homeowner work to sell at the highest possible price given the conditions of the prevailing market.  Working together allows the home to be maintained and occupied during the course of the sale.  This generally is less costly to the lender and is one of the reasons why they entertain short sales. 

In general, short sales are less “shocking” to the market values in comparison to a lender going through the foreclosure process and then reselling the property as an REO.  This should be encouraged where possible.

Tax wise, homeowners still receive a 1099C.   From a credit report perspective, the lender usually won’t report a foreclosure against the homeowner if they sell with a short sale.  A short sale in that instance will be beneficial to the seller’s credit and may be helpful when the seller becomes a buyer and wants to obtain another mortgage in the future. 

In Minnesota we have a unique situation regarding foreclosures.  For owner occupied properties, we have a 6 month right of redemption from the date of the Sheriff’s sale.  Because of the long redemption period, during which no payments are due, many in Minnesota are opting to be foreclosed upon instead so they can live in the home for free.  You see this occurring most often where preservation of a one’s credit rating is no longer important to the homeowner. 

To encourage lenders and homeowners to work together, the government has just created a new law.  The law is H.R. 3648, entitled Mortgage Forgiveness Act of 2007 and was signed into law as of mid December 2007.  Here’s what the law does:  it waives taxes for debts forgiven from the beginning of 2007 to the end of 2009.  This means no more 1099C, at least during this time frame. 

Can you see the implications?  This means that homeowners and lenders can work together to either sell or refinance the existing mortgage debt, without having to recognize the taxes due on the amount forgiven.  It provides an incentive to protect your credit and work out an acceptable solution, such as a short sale.  Income taxes are taken out of the equation since there isn’t anymore inherent tax liability from mortgage forgiveness. 

This should slow down the foreclosure crisis and allow values to stabilize.  This is a good law that should help ease the mortgage and real estate crisis we are facing today.


H.R. 3648 - Public Law 110-142
Signed December 20, 2007
Summary: Generally, individuals who are relieved of their obligation to pay some portion of a mortgage debt on a principal residence between January 1, 2007 and December 31, 2009 will not be required to pay income tax on any amount that is forgiven.

Background: A fundamental principle of the income tax is that a taxpayer must recognize income and pay tax any time a debt of the taxpayer is forgiven or discharged. Exceptions are provided in several circumstances, including bankruptcy, insolvency (as defined by state law) and for some investment real estate. Until this new rule was enacted, however, no exception applied to any amount debt forgiven on a mortgage for a taxpayer's principal residence. Thus, until now, when some portion of a mortgage debt was forgiven, that amount has been treated as taxable income and the borrower has been taxed at ordinary income rates on the forgiven amount, even though there is not cash.

The newly-enacted relief for mortgage debt forgiveness is Congress's response tot he problems generated by the subprime crisis, short sales, rising foreclosure rates and price corrections in some markets. Thus, when a lender forgives some portion of a borrower's mortgage debt in a short sale, a foreclosure, a workout with the lender or some similar circumstance, the borrower will not be required to recognize income or pay tax on the forgiven amount. This relief applies to debts forgiven between January 1, 2007 and December 31, 2009.

Provisions: General.

No income limitation: All borrowers receive the relief, no matter what their income.
Dollar limitation: No more than $2 million of mortgage debt is eligible for the exclusion ($1 million of debt for a married filing separately return).
Relief applies only to an individual's principal residence.
The forgiven mortgage debt must have been secured by that residence.
No relief is available for cash-outs, whether the cash-out takes the form of a refinanced first mortgage, a second mortgage, home equity line of credit or similar arrangement.
Eligible debt is what is called "acquisition indebtedness." This is debt used to acquire, construct or rehabilitate a residence.
Refinanced debt qualifies, so long as the debt does not exceed the original amount of the debt. (Same rule as Mortgage Interest Deduction)
Home equity debt (or second mortgages) qualifies if the funds were used to improve the home. (Borrower must have adequate records, as under current law.)
See cash-outs, above. No amount of a cash-out may be treated as acquisition debt.
Additional Information:

Refinanced Mortgages: The relief does apply to refinanced debt in some circumstances. The rules seek to assure that any debt eligible for the relief is directly related to the acquisition or improvement (such as rehabilitation, expansion, renovation, reconstruction) of the principal residence. Debt used for furnishings (i.e., any movable property) in the home is not eligible for the relief. When the proceeds of any refinanced debt is used for any purpose other than acquisition or improvement, those proceeds are not eligible for the relief.

Principal Residence: A principal residence is defined in the same manner as the rules that apply to the capital gains exclusion on the sale of a principal residence. An individual may not have more than one principal residence at any given time.

Second Homes: As a general matter, the relief does not apply to any debt forgiveness on any mortgage for any second home of the taxpayer. However, if a taxpayer uses a residence (other than his principal residence) solely as an income-producing rental property, already-existing relief provisions might apply, depending on the taxpayer's situation. if the second home property was acquired as a speculative investment (such as for resale rather than rental), relief provisions are unlikely to be available.

In all events an individual who is in a short sale, foreclosure, workout or similar situation on a residence (including condos) other than his principal residence should consult a tax adviser to determine what, if any, relief provisions might be available.

Other Provisions in H.R. 3648

Mortgage Insurance Premiums: The deduction for mortgage insurance premiums is extended through tax year 2010. Income limitations on the deduction will continue to apply.

Surviving Spouses/$500,000 Exclusion: In some circumstances, a surviving spouse is denied eligibility for the full $500,000 exclusion on the sale of his/her principal residence. This most frequently occurs when the residence is not held in joint ownership at the time the spouse who is not on the title dies. In that case, the deceased spouse had no ownership interest, so there is no basis step-up on that half of the property. the surviving spouse is thus eligible only for an exclusion of $250,000. (Had the home been sold during the deceased spouse's lifetime, the full $500,000 exclusion would have applied, so long as they filed a joint return.)

Challenges for the surviving spouse are compounded when this circumstance occurs late in the year. The surviving spouse is often unable to sell the property within the same year that the spouse died. This legislation provides that a surviving spouse may claim the full $500,000 exclusion not only in the year of the deceased spouse's death, but also during the two years after the spouse's death.

Second Homes Converted to Principal Residence: The original House-passed version of this legislation included a provision that would have limited the application of the $250,000/$500,000 exclusion when a second home is converted to a principal residence and later sold. This change was not included in the final legislation that the President signed.