June 5, 2008

MORTGAGE DEBT CANCELLATION RELIEF ACT PASSES

Individuals who are relieved of their obligation to pay part or all 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.  The bill was signed into law on December 20, 2007.

A taxpayer must recognize income and pay tax any time a debt is forgiven or discharged, with some exceptions.   Until now, no exception applied to debt forgiven on a mortgage on a principal residence.  Thus, when a mortgage debt was forgiven, that amount has been treated as taxable income and the borrower has been taxed at ordinary income rates, even when there is no cash. 

The new law is Congress’ response to the subprime crisis, short sales, rising foreclosure rates and price corrections in some markets.  When a lender forgives a 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.

• All borrowers receive the relief, no matter what their income. 
• No more than $2 million of mortgage debt is eligible for the exclusion ($1 million of debt for a married filing separately). 
• 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.)

The relief does apply to refinanced debt in some circumstances.  The law seeks to assure that any debt eligible for the relief is directly related to the acquisition or improvement of the principal residence.  Debt used for furnishings in the home is not eligible.  Proceeds of any refinanced debt used for any purpose other than acquisition or improvement are not eligible.

Other provisions in the new law

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 original House-passed version of this legislation included a provision that would have limited the application of the $250,000/$500,000 exclusion when a second home is converted to a principal residence and later sold.  This change was not included in the final legislation that the President signed. 

Oldfield & Helsdon, PLLC
(253) 564-9500 www.tacomalawfirm.com
and
Olympic Exchange Accommodators, LLC
(866) 309-1031 www.olympic1031.com.

We really do look out for you.