The Effect of the Mortgage Forgiveness Debt Relief Act

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April 24, 2008
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A new law offers beleaguered homeowners limited relief. Congress passed and the President signed the Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA). While it offers some help by excluding from taxable income the amount of forgiven or cancelled mortgage debt, it is effective for a limited period, and there are restrictions on its relief. [More information is available on LexisNexis Tax Center. Suggested sources: Tax Advisor — Federal Topical, Section 1A:8, Tax Notes Today, BNA TaxCore.]

Tax on Cancellation of Indebtedness Income — Bankruptcy and Insolvency Exceptions

The Internal Revenue Code provides that, when all or part of a taxpayer’s debt is forgiven, the amount of the canceled debt is ordinarily included in gross income [IRC Section 61(a)(12)]. IRC Section 108 provides two exceptions to this rule that apply to canceled home mortgage debt: a borrower may exclude such debt from gross income if (1) the debt is discharged in Title 11 bankruptcy, or (2) the borrower is insolvent (has liabilities that exceed the fair market value of her assets, determined immediately prior to discharge).

In addition to the IRC Section 108 bankruptcy and insolvency exclusions, there are other circumstances when income from the cancellation or forgiveness of debt may be excluded. For example, a taxpayer with non-recourse debt will not realize forgiven income.

The amount of discharge of indebtedness excluded from income by an insolvent debtor not in a Title 11 bankruptcy case cannot exceed the amount by which the debtor was insolvent.

The MFDRA adds IRC Section 108(a)(1)(E) to include discharged qualified residential debt to the types of debt that are excludable from gross income and that do not result in "phantom income" subject to tax. [More information is available on LexisNexis Tax Center. Suggested source: Tax Advisor — Federal Code.]

In addition to debt forgiven in connection with the restructuring or refinancing of an obligation such as a mortgage, "phantom income" can also relate to: (1) foreclosures; (2) short sales; (3) deed in lieu of foreclosures; and (4) arrangements that mitigate homeowner debt.

The amount of discharge of indebtedness generally is equal to the difference between the issue price of the debt being cancelled and the amount used to satisfy the debt.

The MFDRA excludes from gross income the amount of any discharge of indebtedness income by reason of a discharge (in whole or in part) of "qualified principal residence indebtedness," which the new law defines as acquisition indebtedness with respect to the taxpayer's principal residence. Acquisition indebtedness includes debt incurred in acquiring, constructing, or substantially improving a principal residence secured by the residence [IRC Section 163(h)(3)(B)]. It also includes refinancing of such indebtedness to the extent that the refinancing does not exceed the amount of the total refinanced indebtedness.

If, immediately before the discharge, only a portion of a discharged indebtedness is qualified principal residence indebtedness, the exclusion applies only to the amount discharged as exceeds the portion of the debt which is not qualified principal residence indebtedness.

The basis of the individual's principal residence must be reduced by the amount excluded from income.

The exclusion provided by the new law does not apply to a taxpayer in a Title 11 case. In the case of an insolvent taxpayer not in a Title 11 case, the exclusion under the MFDRA applies unless the taxpayer elects to have the pre-MFDRA exclusion apply.

Limitations and Restrictions

The MFDRA contains the following restrictions concerning the taxation of forgiven mortgage debt:

  • it is temporary and effective only for debt discharged after January 1, 2007, and before January 1, 2010;
  • it does not apply to the discharge of a loan if the discharge is on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer;
  • it limits the amount of qualified excludable debt to $2 million for a married couple filing jointly ($1 million if filing separately); and
  • it applies only to principal residences.

The MFDRA facilitates the forgiveness of mortgage debt by requiring that the amount of forgiven debt be subtracted from the property’s basis. Doing so effectively defers the payment of the tax on the amount forgiven until the property is sold. While this relief somewhat assuages the fears of borrowers, it has been criticized for providing beleaguered homeowners with too little assistance, too late.

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