Has this law been passed?
Yes. President Bush signed the bill into law on December
20, 2007. Its official title is H.R. 3648 - Public Law 110-142.
How does it work? The
cancellation of mortgage debt rules apply only to a
limited number of taxpayers.
The provision is best understood with an example.
Assume a family purchased their home for $100,000, with a
mortgage of $95,000. Later, they need to sell the home. They find that the value
of homes in their area has declined and they can sell for only $89,000. At the
time of the sale, the outstanding balance on a mortgage might be, for example,
$92,000. Thus, there will not be enough cash at settlement to repay the lender
the full balance of the mortgage. In some limited circumstances, a lender might
forgive the amount of the balance that exceeds the
purchase price ($3,000 in this example).
Is there precedent for this type of
relief? Yes. The Hurricane Katrina relief package enacted in 2005 (H.R.
3768, 109th
Congress) provided that individuals who either lost their homes or sustained
economic damage to them would not be required to pay tax on forgiven mortgage
debt. This relief, however, applied only
in the Hurricane Katrina relief zone and was effective
only between August 25, 2005
and January 1, 2007.
Will this provision apply to commercial
real estate? Current law already provides a similar rule that grants
relief to debt-burdened commercial real estate and rental properties. The
proposal would grant relief for principal residences sold by their owners or to
borrowers who arrange a “workout” with a lender that reduces the outstanding
balance of the mortgage. If the provision is enacted, homeowners would be
treated the same as owners of commercial and rental property when mortgage debts
are forgiven.
What are some situations that might
trigger this provision? Historically, residential real estate has almost
always appreciated in value. However, in some limited situations, values in some
neighborhoods fall, often through no fault of the owners. For example, a major
employer might leave an area, a military base could close or environmental
problems might emerge. (Areas that have been affected in the past include Texas
during the oil downturn of the 80’s, Denver and Phoenix during the early 90’s
credit crunch and southern California during the aerospace downturn of the early
90’s.) In other circumstances, a homeowner might be in a situation where they
needed to sell in a down market to relocate, because of job loss or because of
health reversals. It seems particularly unfair to tax phantom income at a time
when a taxpayer is in reduced economic circumstances.
What if a property declines in value,
but is not sold? The provision would not apply. The provision applies
only at the time of sale or other disposition or when there is a workout with
the lender.
Do all lenders forgive mortgage debt
when property values decline? No. In states with applicable laws, the
lender may require a repayment arrangement, particularly if the borrower has
other assets.
What is the revenue effect of the
proposal? In 2000, the revenue estimate for an identical bill was a loss
of $27 million over 5 years and a loss of $64 million over 10 years. The 2007
version reflects dramatic market changes. The current legislative relief is
scored as losing $1.3 billion over 10 years.
Mortgage Debt
Cancellation Relief - H.R. 3648 - Public Law 110-142 General Information and
Provisions
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.
General Provisions of Public Law 110-142:
- 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 Provisions of Public Law 110-142:
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.
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 new law signed by the President does not include a
provision limiting the application of the $250,000/$500,000 exclusion when a
second home is converted to a principal residence and late
Background Information
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 no cash.
The newly-enacted relief for mortgage debt forgiveness is
Congress's response to the 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.
Copyright NATIONAL ASSOCIATION OF REALTORS®
Headquarters: 430 North Michigan Avenue, Chicago, IL. 60611-4087
DC Office: 500 New Jersey Avenue, NW, Washington, DC 20001-2020
1-800-874-6500
