Mortgage Forgiveness Debt Relief Act of 2007, The

Agency Sales, Sep 2008 by Daskal, Melvin H

By now almost all of you have heard about this tax act, hurriedly passed in the waning hours of 2007 - and a few of you may even really understand it. Unfortunately, a number of of you may have been caught in the sub-prime adjustable rate mortgage debacle and bumped up against the provisions of this law. And some of you have found out to your absolute horror that this high-sounding law would not be of the slightest help to you! The supposed highlight of this law is a three-year exception to the normal law on debt forgiveness - but whom does it apply to and really help?

The Old Rules on Debt Discharge

Here is an example of the way it used to work (and still does for many unsuspecting individuals, as we will later discuss). EXAMPLE: Assume a $350,000 mortgage, an individual whose adjustable rate mortgage payment just went up another $1,500 a month, so he or she stopped making mortgage payments, the house went into foreclosure and has now been sold by the bank in the terrible falling home market for $275,000.

The shortfall and loss to the bank is $75,000 ($350,000-$275,000). That "forgiveness of indebtedness income" is reported to the IRS and then is legally ordinary income in the year of the sale to the individual that defaulted on the mortgage. So you had this poor soul who just lost his house also owing the IRS (and probably the state) ordinary income taxes on the $75,000. This is the situation that is (somewhat) addressed by this law.

The New Law

The new law (effective January 1, 2007) is intended to grant forgiveness from those old rules that created taxable income, as in the example just described. But here are the restrictions that you must understand - and that can prevent many of you from qualifying for any relief:

* The forgiven mortgage debt rules only apply to your principal residence. Not one penny of help for a second (or third) residence (i.e., vacation home property) or investment property.

* As much as $2 million can be excluded from debt discharge-forgiveness income - but only for the years 2007, 2008 and 2009 (or $1 million for a married individual filing separately).

* BIG RESTRICTION TRAP: The discharged-forgiven mortgage debt (secured by the primary residence) must have been entirely used to purchase, improve, or build your principal residence. This provision will probably kill the chances for more people than it will help! CAUTION: This means that home equity loans and/or "cash-out refinancing" loans do not qualify for the mortgage waiver (unless the additional funds were also used to improve your primary residence - highly unlikely). So the refinanced mortgage for a higher amount or home equity loan used to pay off credit cards, buy a car, take a trip and similar will not qualify for forgiveness!

* The amount of forgiveness is prorated in cases where only part of the indebtedness qualifies as just described. However, in many/most cases it will be the increased refinancing debt that does not qualify for forgiveness (see following for an example).

* The old rules that enable one to avoid taxable income on debt forgiveness still apply. They are insolvency and/or farm or business debts. The new exclusion does not exactly apply to Chapter 11 bankruptcy, although insolvency usually results.

Remember the constant ads on radio and television that went about like this - "Why pay 20 percent in credit card interest? Refinance and increase your mortgage at only 6 percent, or take a home equity loan, and either way use those additional proceeds to pay off all those credit cards? How can you lose?" Now it's exactly those people who cannot qualify to avoid taxable income if they default on their mortgage.

To reiterate: You can only qualify for a full tax-free cancellation of a mortgage default if (among other conditions) the entire forgiven mortgage funds were used to purchase, improve or build your principal residence.

PREDICTION: Given these regulations, my best estimate is that only about 5 percent-15 percent of those unfortunate individuals will qualify for this debt income forgiveness. However, since these new rules apply all the way up to December 31, 2009, perhaps you should save this article in case you fall into this kind of tax trap.

Pro-Rated Forgiveness Example

As stated above, only part of your mortgage may qualify for forgiveness.

EXAMPLE: Primary residence was purchased for $600,000 in early 2005 with a mortgage granted at that time for $550,000. However, in late 2006 they refinanced and obtained a new mortgage for $650,000. The extra $100,000 was spent to pay off all credit cards, a new car, and a vacation in Europe.

In early 2008 they could not make the increased mortgage payments and the house was foreclosed. The bank sold the house for $525,000 (its fair market value). The total forgiveness of indebtedness income is $125,000 ($650,000 mortgage less $525,000 selling price/ market value).

Under the new law, for federal tax purposes, they are only forgiven $25,000 ($550,000 original acquisition debt mortgage less $525,000 selling price). They still have $100,000 of ordinary income from forgiveness of indebtedness that did not qualify under this new law. Which, of course, is the exact amount that they took from the mortgage increase and did not spend it to improve the existing house.