Homeowners found three attractive tax breaks among their holiday presents, thanks to the federal Mortgage Forgiveness Debt Relief Act of 2007, which was enacted in December.
3 new tax breaks:
- Homeowners who experience a foreclosure, short sale, deed-in-lieu of foreclosure or loan modification may be able to exclude lender-forgiven mortgage debt from taxable ordinary income.
- Homeowners may be able to deduct the cost of mortgage insurance.
- A homeowner whose spouse has died may be allowed up to two years to exclude $500,000 of profit from the sale of a principal residence from capital gains tax.
Forgiven debt may be free from income tax
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The first tax break concerns forgiveness of debt, which occurs when a lender forgoes repayment of principal and/or interest the borrower owes.
Typically, discharged debt is considered ordinary income to the borrower for income tax purposes. The new law allows taxpayers to exclude this amount and thus escape the tax liability.
"When you're worried about making your payments, higher taxes are the last thing you need to worry about. So this bill will create a three-year window for homeowners to refinance their mortgage and pay no taxes on any debt forgiveness that they receive," President Bush said in his remarks upon signing the law.
Lenders are required to report forgiveness of debt to the Internal Revenue Service, which means taxpayers likely will need to note the amount and the reason for the exclusion on their tax returns. Consult a qualified tax professional for more information and advice about your situation.
Exceptions allowed for nonrecourse loans, insolvency, bankruptcy
It's difficult to figure out how many people might qualify, because three existing exemptions already shielded many homeowners from this tax liability, according to Sterling Watkins, mortgage broker and owner of Short Sale Services in Folsom, Calif.
"In my experience, the amount of people who will benefit will be small because most of them, if they qualified for a short sale, didn't have a (tax) problem," he says.
There are three main existing exemptions.
First, in some states, such as California, all purchase-money home loans are required to be "nonrecourse" debt, which means the lender can't pursue the borrower for additional money that's still owed after the property is sold.
A "recourse" loan, on the other hand, means the borrower is personally responsible for the debt and must pay the difference if the sale of the property doesn't pay off the balance that's owed to the lender.
Rules for debt forgiveness:
"In Texas, for example, which is one of the recourse states, they have a different attitude about collecting loans. They basically follow you around until they get the money back. They still do short sales and they accept discounts to avoid having to chase someone, but they bargain from a different perspective," Watkins says.
The distinction is crucial because the lender can pursue the debt on a recourse loan even if a foreclosure or short sale occurred; but without recourse, there is no debt to be forgiven and thus no ordinary-income tax liability for the borrower. The new tax break means borrowers who have a recourse loan also can avoid the tax liability.
Second, borrowers who are insolvent are relieved from ordinary income tax liability on forgiveness of debt to the degree of their negative net worth, Watkins explained. For example, an individual whose assets totaled $400,000 and whose debts totaled $500,000 would have a negative net worth of $100,000. Forgiveness of debt on a principal residence acquisition loan up to that amount wouldn't be subject to federal income tax.
Third, forgiveness of debt tax liability is wiped out if the taxpayer files for bankruptcy. That's not a free ride, because bankruptcy is subject to its own costs, hassles and credit implications.
A capital gain that resulted from a foreclosure, short sale or deed in lieu of foreclosure may still be subject to taxation. This situation is rare, since homeowners who experience these events typically owe more than their home is worth and any capital gain might be subject to a separate exclusion.
"Even though you have forgiveness of debt (excluded) as ordinary income, if you do a short sale or foreclosure, that money would be considered part of the proceeds from the sale of the property, so you could theoretically still have some capital gain on a short sale or foreclosure without going into bankruptcy or being insolvent," Roth says.
Mortgage insurance deduction extended
The second tax break concerns mortgage insurance, which is paid for by the borrower, but protects the lender if the borrower defaults on the loan.
The new law extends a one-year deduction of mortgage insurance premiums that was effective in 2007 for three more years, 2008, 2009 and 2010. That time frame means the deduction is allowable only for mortgage insurance on loans that were originated after Dec. 31, 2006, and before Jan. 1, 2011, unless the tax break is further extended in the future.
The full deduction is available only to taxpayers whose adjusted gross income is less than $100,000. A partial deduction is allowed for adjusted gross incomes up to $109,000. The deduction is worth $350 for the average taxpayer, according to Mortgage Insurance Companies of America, an industry association.
This deduction is "aimed at people in the subprime loan category because mortgage insurance is only required if (the borrower) puts down less than 20 percent on the purchase of a home. It's targeted at the zero-down, 5 percent down, 10 percent down (borrowers)," Roth says.
Surviving spouses allowed more time to sell
The third tax break concerns capital gains tax on the sale of a principal residence when a married person's spouse dies. Federal law allows singles and married couples to exclude $250,000 and $500,000, respectively, of the gain on the sale of their home from capital gains tax if certain tests are met.
The differential treatment on the basis of marital status meant that a person whose spouse died had to sell his or her home in the same tax year as the spouse's death to take advantage of the larger tax break.
"If your spouse died in December, unless you could sell by December 31, you could only exclude $250,000, instead of $500,000, so you could end up with a horrendous tax bill on the sale of the home, whereas if your spouse died in January, you didn't have that problem," Roth says.
The new law allows a surviving spouse to claim the $500,000 if the home is sold within two years after the date of the spouse's death, which eliminates the tax liability on an additional $250,000 of capital gain if the other tests are met as well.
Tax breaks expected to cost U.S. Treasury
Tax breaks are never free, since the government collects less money from taxpayers as a result. The Congressional Budget Office, in a September 2007 report, estimated that the forgiveness of debt exclusion on principal residences would decrease federal tax revenues by $179 million in 2008 and $318 million in 2009. (The retroactive 2007 tax year wasn't included in the analysis.) The extension of the mortgage insurance tax break is expected to decrease tax collections by $15 million in 2008, $109 million in 2009 and $142 million in 2010. States are likely to forfeit some tax dollars too, because state tax codes typically use federal adjusted gross income to calculate income taxes.
Opinions vary as to whether these tax breaks benefit society and the U.S. economy as whole in addition to individual taxpayers.
President Bush says the debt relief act was "a really good piece of legislation" that would "increase the incentive for borrowers and lenders to work together to refinance loans" and "allow American families to secure lower mortgage payments without facing higher taxes."
But the Tax Foundation, a nonprofit, nonpartisan research group in Washington, D.C., says that housing is one of the most preferred asset classes in the tax code. Therefore, the organization says, housing shouldn't be the beneficiary of any more tax breaks.
Still, strapped borrowers will probably welcome any legislation aimed at helping those who are upside down on their homes.