In my last post, I opened by introducing Michael C. Gray and his extremely informative article on the tax ramifications of short vs foreclosures. I have included another portion of this article where he discusses the Mortgage Debt Relief Act of 2007…and how it will affect you directly.
Tax relief enacted for recourse mortgage on principal residence debt forgiveness.
Congress has passed and President Bush has approved H.R. 3648, the “Mortgage Forgiveness Debt Relief Act of 2007.” The legislation is effective for discharges of indebtedness on or after January 1, 2007 and before January 1, 2010. The Federal Bailout Legislation H.R. 1424, passed on October 3, 2008, extended this relief through December 31, 2012.
Under the new law, a discharge of “qualified principal residence indebtedness” is excluded from taxable income. “Qualified principal residence indebtedness” is acquisition indebtedness secured by the principal residence of a taxpayer as defined for the deduction of residential mortgage interest, but the limit is $2,000,000 for the exclusion ($1,000,000 for the mortgage interest deduction) and $1,000,000 for married persons filing a separate return ($500,000 for the mortgage interest deduction). Also, the exclusion only applies to a mortgage secured by the principal residence of the taxpayer.
The election to exclude the income from discharge of principal residence indebtedness is made on Form 982 (Re. February 2008), Part I, lines 1.e and 2. According to IRS Publication 4681, a basis reduction amount is entered at Part II, like 10.b. only if the taxpayer still owns the residence after the debt cancellation.4 IRS Publications aren’t considered legal authority and I haven’t found any other authority for not making a basis adjustment when the debt cancellation happens at the same time as a foreclosure or short sale.
The exclusion does not apply if the discharge relates to providing services to the lender or any other factor not related to a decline in the value of the residence or the financial condition of the taxpayer/borrower.
According to IRS Publication 4681, if the taxpayer continues to own the home after the debt cancellation, the tax basis of the residence (cost used to determine taxable gain or loss on sale) is reduced by any amount of discharge of indebtedness excluded from taxable income, but not below zero. There is no basis adjustment if the debt cancellation happens with a foreclosure or short sale. There will be two calculations. (1) Cancellation of debt income eligible for exclusion. (2) Sale of residence to apply applicable exclusion.
The new exclusion of income for discharge of acquisition indebtedness for a principal residence takes precedence over the exclusion relating to insolvency (discussed below), unless the taxpayer elects otherwise.
For example, if the previous example for a recourse debt was eligible for the exclusion, here are the tax results:
| Recourse debt | $500,000 |
| Fair market value | 450,000 |
| Cancellation of debt excluded from taxable income | 50,000 |
| Fair market value | $450,000 |
| Tax basis | 300,000 |
| Gain | $150,000 |
If the holding period requirements are met, the above gain would qualify for the exclusion ($500,000 married, joint or $250,000 single) for sale of a principal residence.
(Remember the foreclosure of a non-recourse mortgage is not a discharge of indebtedness, but a “sale” of the residence in satisfaction of the mortgage. Therefore, such a foreclosure won’t qualify for the new exclusion, but may qualify for the exclusion of gain for sale of a principal residence. Also, since the balance of acquisition indebtedness is almost always less than the tax basis (cost) of the residence, it would be highly unusual for there to be a gain from a foreclosure.)
What happens with a “short sale”?
Short sales are taxed under the same rules as foreclosures.
Recourse debt cancellation is not satisfied with the surrender of the property, so any debt not satisfied with the sale proceeds would be taxable as cancellation of debt income, except for certain “qualified principal residence indebtedness.” See section on “tax relief” above. (Rev. Rul. 92-99, 1992-2 CB 518. Also see Treasury Regulations Section 1.1001-2(a)(2).)
Therefore, the tax consequences would be similar to the “recourse debt” example, above. The buyer and seller might also have legal concerns about whether the lender would consent to the transaction and whether (for recourse debt) the lender would in fact forgive the debt.
For example, for a recourse debt short sale,
| Net sale proceeds | $450,000 |
| Tax basis | 300,000 |
| Gain | $150,000 |
| Debt | $500,000 |
| Pay off using net sale proceeds | 450,000 |
| Cancellation of debt (ordinary income) | $ 50,000 |
(If the cancellation of debt was for “qualified principal residence indebtedness,” it will be excluded from taxable income and be subtracted from the tax basis of the residence. See the section on “tax relief” above.)
For non-recourse debt short sales when the seller and buyer require the cancellation of the debt by the lender as a condition of the sale, the debt cancellation is included in the sale proceeds, like for a foreclosure.5
Therefore, a “short sale” can be a viable alternative to a foreclosure for debtors with non-recourse debt and who qualify for the exclusion from income of the gain from the sale of a principal residence.
What about selling expenses for a recourse mortgage?
For simplicity, I have disregarded selling expenses in the above discussion. For a short sale, selling expenses reduce the sales proceeds available to reduce the loan. For a foreclosure or deed in lieu of foreclosure, selling expenses are added to the debt. (See Jerry Myers Johnson v. Commissioner, TC Memo 1999-162, affirmed CA-4, 2001-1 USTC ¶ 50,391.) The net result should be similar, assuming the fair market value of the property equals the selling price for a short sale.
For example, for foreclosure of a recourse debt,
| Recourse mortgage balance | $500,000 |
| Selling expenses | 50,000 |
| Total debt | $550,000 |
| Fair market value | 450,000 |
| Cancellation of debt (ordinary income) | $100,000 |
(If the cancellation of debt was for “qualified principal residence indebtedness,” it will be excluded from taxable income. According to IRS Publication 4681, if the cancellation of indebtedness happened relating to a short sale, no basis adjustment would be required. If the taxpayer still owned the home after the debt cancellation, the exclusion amount would be subtracted from the tax basis of the residence. See the section on “tax relief” above.)
| Fair market value | $450,000 |
| Tax basis | -300,000 |
| Selling expenses | -50,000 |
| Gain | $100,000 |
For example, for a recourse debt short sale,
| Sales price | $450,000 |
| Selling expenses | -50,000 |
| Tax basis | -300,000 |
| Gain | $100,000 |
| Recourse mortgage balance | $500,000 |
| Pay off using net sale proceeds ($450,000 sales price – $50,000 selling expenses) |
400,000 |
| Cancellation of debt (ordinary income) | $100,000 |
(Same caveat for “qualified principal residence indebtedness” as above.)
The information provided by Michael C. Gray is Invaluable and Empowering. Understanding the Mortgage Debt Relief Act of 2006 is imperative. when you see the relief involved…this is Empowering!
