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Residence Mortgage Forgiveness Tax Relief - Finally!

This is an update to the previous article Residence Mortgage Forgiveness Tax Relief since it is now law. We've created a new page rather than updating the previous page since it contain other useful information.

One of the biggest tax issues for 2007 relates to mortgage cancellation. The problem is that many homes are "upside down" in that the current mortgage exceeds the fair market value of the house. Complicate this with those mortgages being fixed at an atrificially low interest rate with a change after a few years. Many of those adjustments are now starting to happen, and as they do, the monthly payment increases significantly.

This becomes a tax issue because, in many cases, the loan amount that is "forgiven" is taxable income. So not only does a family suffer from the loss of their home, but then they are hit with a large tax bill.

Congress finally hammered out a law to provide temporary relief on this, and President Bush has singed the law. Here are the key provisions related to forclosures (with more details below):

  • The provision only relates to mortgage debt cancelled between January 1, 2007 and December 31, 2009.
  • It only applies to your primary residence.
  • It only covers acquisition debt
  • The relief is limited to $2,000,000.
  • There must be a basis adjustment for any tax relief provided.

Three Years Only
Without reviewing the committee notes, we do not know why the provision applies to only three years. It is possible that Congress decided that the established rules were generally appropriate, but due to the current massive crisis, they wanted to provide temporary relief to weather the current storm. That suggests that they assume this will be sufficient time for people to recover and hopefully people will be better informed and not make these same mistakes in the future. More likely, then did not want to create additional taxes to offset the potential loss of revenue here-on, so capped the provision to limit the offsets required.

Primary Residence
By limiting this to primary residence Congress truly wanted to protect the basic homeowner who finally was able to buy into a house (generally speaking). So there is no relief on a second home. Nor is there relief for investment property. The provisions are limited to "personal residence" as defined in IRC 121, which applies the "2 of 5" rule. IRC 121 does not provide for any compromise to the 2-year rule, so presumably those exceptions will not apply here.

Acquisition Debt Only
By limiting the relief to the acquisition debt Congress specifically excluded any extra help to those who have used the equity in their houses for purposes other than the purchase or construction of their house. Acquisition debt does include the cost of major remodels, but generally not major repairs. Note that the acquisition debt is not necessarily the current balance of your mortgage. The acquisition debt decreases with each payment that includes principle in addition to interest. It does not increase monthly with a negative amortization loan. So if you have a Home Equity Line of Credit (HELOC) and have used that for non-house expenses such as vacation, a car, college tuition, paying off credit cards, or whatever, this loan is not covered by the bill.

Limited to $2,000,000
Congress determined that there should be some limit to the amount of relief provided. So they set the maximum relief at $2,000,000. Any cancellation of debt over this amount will not receive relief under the provisions of this bill.

Basis Adjustment
Finally, you must adjust your basis for any relief received under this provision. This has the potential of increasing your capital gains on the house. ("Basis" is subtracted from the selling price to determine your gain.) However, in most cases this will not be a consideration. This is because IRS 121 allows a seller to exclude $250,000 (or $500,000 if married filing joint) of the capital gains on the house, providing that the seller has both owned and lived in the house for 2 of the preceding 5 years. Since this same requirement is required to receive any relief from the bill, any gain will typically be less than the exclusion. (There could be an issue if you have excluded gain under this provision within the last two years. We will assist you on this when we work on your taxes.)

Other Comments

There are other provisions in the same law but it is best if those are dealt with separately. The actual bill is not too long. The text of bills are available from the Library of Congress web site www.thomas.gov but locating a specific bill is non-trival and you also must wade through its history to be certain that you find the last version that was actually enacted. In this case we are provideing the text of HR 3648 as enacted on our site.

"Tax software is no substitute for tax knowledge."

Any views expressed herein are based on our best information. The content of this web site was written as general information without specific individual information and thus may not apply in all situations. This material was not written, and cannot be used by the taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer.

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Janelle Ogg, EA
Richard Ogg, EA