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On December 20, 2007, the President signed into law the "Mortgage Forgiveness Debt Relief Act of 2007" (Public Law 110-142, hereinafter the "Act"), which addresses the aftermath of the recent burst of the "housing bubble" in the U.S. The Act seeks to temper the effect of real property values that have rapidly increased, leading to refinancing and mortgage payments at levels unsustainable relative to incomes, and the subsequent and sharp decreases in real property values. This has left many homeowners owing mortgage debt greater than the value of their property. Refinancing as a remedial effort has, therefore, become more difficult as property values continue to decline. This has also created the perverse incentive for mortgage borrowers to "walk away" from their mortgages, allowing the property slip into foreclosure.
Lenders and borrowers have been faced with challenges to resolve indebtedness issues caused by high default rates on mortgages. Some transactions are resulting in cancellation of debt, in the form of loan restructuring, reducing principal loan balances, and in other cases, triggering foreclosure. Under the tax law prior to December 20, 2007, if a lender forgave or cancelled any of this debt, the amount forgiven or canceled was treated as ordinary income (cancellation of debt income) subject to income tax.
Taxpayers who are insolvent or bankrupt may exclude from gross income any amount otherwise includible by reason of discharge of indebtedness under current Internal Revenue Code Section 108(a)(1)(A)-(D). The Act seeks to relieve financially burdened taxpayers who did not otherwise qualify for exceptions under prior law by virtue of being bankrupt or insolvent. Thus, solvent and/or non-bankrupt taxpayers qualifying under the Act may exclude cancellation of debt income and avoid the threat of a higher tax bill as a result of refinancing or foreclosure. By providing homeowners with incentives to work out their mortgages rather than walk away in foreclosure, the Act reassures the economic community that declining housing markets and sub-prime mortgage markets will not deter home ownership in the future. The Act also serves to prevent a glut of foreclosed properties on the market, further depressing value.
Foreclosure Relief vs. Mortgage Renegotiation
Under the tax law prior to December 20, 2007, the amount of any debt forgiven or cancelled is treated as taxable income to the taxpayer (subject to the abovementioned exceptions for insolvent and/or bankrupt taxpayers), under the theory that a reduction in liability leads to an increase in net worth. (Economists Robert M. Haig and Henry C. Simons developed an operational definition of "income" as "consumption plus change in net worth"). Cancellation of debt resulting in taxable income can occur in several ways: lenders may restructure a loan and forgive some debt, while allowing the homeowner to retain ownership of the home; or lenders can choose to foreclose on the property. Tax law treats the discharge of debt in the same way, regardless of whether the home is retained or lost.
When a lender forecloses on a property and the proceeds from the foreclosure sale are insufficient to repay the outstanding mortgage, part or all of the unpaid debt that may be forgiven by the lender is considered taxable income. For example, when a taxpayer has qualified residential debt in the sum of $500,000 and the property is disposed of at a foreclosure sale for $400,000, the remaining $100,000 discharged by the lender is taxable income to the taxpayer. Assuming a tax rate of 15% for purposes of simplicity, the taxpayer will owe $15,000 in income taxes on the cancellation of debt income ($100,000 x 15%, assuming a marginal tax rate does not apply).
Similarly, a lender may decide not to foreclose on the property, but instead forgive a portion of the principal of a loan to result in (a) a larger net of the principal on that loan than foreclosure may permit; (b) a lower monthly payment for the taxpayer; and (c) the taxpayer retaining ownership of the property. Under the tax law prior to December 20, 2007, any amount of the principal forgiven by the lender would result in taxable income to the taxpayer, as above.
The tax law, as amended by the Act, excludes from taxation up to $2 million of indebtedness that is secured by a principal residence. This relief will be available to all taxpayers for three years, retroactive to January 1, 2007 and through December 31, 2009 (see text of Public Law 110-142). Concerns during the House's proposal of the bill (H.R. 3648) included the potential for homeowners to attempt to qualify other types of indebtedness, such as second liens or debt associated with a second home or investment property, for this relief. As a result, the Act narrowed the applicability of the exclusion offered to "qualified residential debt" or "qualified indebtedness", which is defined as "debt, limited to $2 million ($1 million if married filing separately), incurred in acquiring, constructing or substantially improving the taxpayer's principal residence that is secured by such residence" (See " CCH Tax Briefing, 2007 Year End Legislation Special Report", http://tax.cchgroup.com/legislation/2007-year-end.pdf). It also includes refinancing of this debt to the extent the refinancing does not exceed the amount of refinanced indebtedness. In this way, taxpayers are prevented from discharging home equity debt taken against their residences and not reinvested into the home as capital improvements, or any debt associated with secondary properties. The passage of this Act will account for more than $600 million in taxpayer relief through December 31, 2009 ( Id).
Basis Reduction; Gain from Sale of Principal Residence
In situations where a lender forecloses in exchange for cancellation of debt, the homeowner realizes gain in the amount that the fair market value of the property exceeds the adjusted basis in the property. A taxpayer can potentially realize cancellation of debt income as well as gain from the disposition of property.
Prior to the passage of the Act, those taxpayers who qualify under Section 108 for the exclusion of cancelled debt income must also reduce the basis in their property by the amount of the cancelled debt. Under the Act, all taxpayers who qualify for exclusion of cancellation of debt income must also reduce the basis in their principal residence by the amount of the cancelled debt. This will require the taxpayer to account for the benefit of the excluded cancellation of debt income that would otherwise decrease their tax liability over the next few years.
The House considered whether and how to adjust basis, as this can cause the recognition of future gain as recapture of cancelled debt upon eventual sale of the property. The Act states, however, that deferred gains will be taxed at capital gains rates, not ordinary income rates, upon the eventual sale of property where ordinary income for debt forgiveness is not immediately recognized. The proposed legislation also discussed when basis should be adjusted, acknowledging that if adjustments occurred in the year after discharge, homeowners losing their homes at the time of the debt cancellation would have already disposed of the property.
Internal Revenue Code Section 121 excludes from gross income up to $250,000 for single taxpayers (and $500,000 for married taxpayers filing jointly) of gain from the sale of a principal residence, assuming taxpayers meet the requirements of the "ownership and use test" described in the statute (taxpayers must have owned and used the property as a principal residence for at least two out of the last five years ending on the date of sale). The Act, in conjunction with this Code section, makes it possible for the cancellation of debt to be a potentially tax-free transaction for the homeowner.
Tax Policy Considerations, Estate Planning Considerations & Effect on Real Property Market
One of the most prominent criticisms of the Act is that it has the potential to affect all taxpayers, not just those with cancelled debt income. For instance, identical taxpayers who have identical incomes may not pay the identical amount in income tax, due to the fact that one taxpayer may exclude cancelled debt income under the Act. Similarly, the amount of the exclusion is more valuable to taxpayers in higher tax brackets. This would mean that taxpayers who earn more income reap a greater tax benefit under the Act. In addition, if homeownership is concentrated among taxpayers with higher incomes, the unequal treatment among taxpayers is further magnified. Opponents of the Act have argued that with this Act as a "backstop", homeowners may feel encouraged to purchase properties that would not otherwise be affordable, and could inspire a wave of reckless acquisitions and a further ripple in the already unstable housing market.
The Act applies to discharges of indebtedness on or after January 1, 2007 through December 31, 2010. The future of the housing and lending markets is uncertain, and the Act will help to mitigate the negative financial fallout to homeowners as a result of volatile housing and mortgage markets. Time will tell if the Act can fulfill its stated policy goals of minimizing hardship in the event of foreclosures and ensuring that homeownership is not threatened by tax policy (See "CRS Report for Congress: Analysis of the Proposed Tax Exclusion for Canceled Mortgage Debt Income", Pamela J. Jackson and Erika Lunder, October 16, 2007).
About the Author
Ms. Ciaramella is an associate at McLaughlin & Stern, LLP in New York City where she practices estate planning and the administration of trusts and estates. She is also an adjunct professor of Law at Pace University School of Law, where she teaches estate planning.