The Mortgage Forgiveness Debt Relief Act of 2007 has introduced a new paradigm of tax strategies for those who are falling behind on their home mortgage payments (or anticipate falling behind as the result of a pending adjustable rate mortgage reset).

Set against the urgent need to have these new relief provisions work not only for the homeowner but also for investors, the housing market and the national economy, the new law has been generously drafted and likely will be liberally interpreted to fulfill its goals. Unfortunately, not all of the new statutory language is straightforward, nor does it offer full answers to all issues that may arise.

The act excludes from taxation discharges involving up to $2 million of indebtedness that is secured by a principal residence and is incurred in the acquisition, construction or substantial improvement of the residence. This new "principal residence" exclusion as passed applies to debt relief that takes place during a three-year period, starting retroactively on Jan. 1, 2007, and ending on Dec. 31, 2009.

The new law may be applied to a variety of situations under which mortgage debt may be forgiven. These include workouts, foreclosures, short sales, and deeds in lieu of foreclosures. Each has both unique and common tax issues.

MORTGAGE WORKOUTS

The Bush administration is putting tremendous pressure on major lenders to renegotiate subprime mortgage debt. One standard workout solution being offered extends the "teaser" rates, or at least rates that are more manageable, over the next three to five years. The tax impact of that solution, however, is not affected by the new law. Because prepayment generally is allowed, only reduction of the principal amount of mortgage indebtedness -- and not interest -- would result in forgiveness-of-indebtedness income.

Under the standing tax benefit rule, any indebtedness income realized as the result of forgiveness of part of the new, higher interest rate on an adjustable rate reset is offset by a reciprocal mortgage interest deduction. Therefore, the new principal residence exclusion rule is redundant in these "wash" situations, except if the interest rate reduction is partially on a home equity loan that was a cashout of more than $100,000. In that case, mortgage interest for that excess portion would not be deductible and, therefore, the tax benefit rule does not apply.

To the extent that debt forgiveness is income on $100,000-plus cashouts, however, it is also not covered by the new principal residence exclusion since it also is not debt incurred "in the acquisition, construction or substantial improvement" of the principal residence. For these cashouts, therefore, application of the insolvency exception under Code Section 108, if applicable, would be the only exclusion available to prevent that income from being recognized.

If a workout results in a lower overall principal amount owed on the note, only then is that amount realized as income when the agreement is reached. It also would be recognized unless one of the Sec. 108 exceptions applies, the most common in the present circumstances being the new principal residence exclusion and the long-standing insolvency exclusion.

AMOUNT OF FORGIVEN DEBT

In most mortgage workouts, it is easy to determine what potentially will be considered indebtedness income: It is equal to the old principal amount due on the mortgage less the new principal amount due. In foreclosure, short sale or deed-in-lieu-of-foreclosure situations, however, determination of indebtedness income often is not so easy.

In a foreclosure sale, expenses surrounding the foreclosure may or may not be required to be picked up by the homeowner and, therefore, may increase or decrease what proceeds the lender ultimately receives to pay off the principal. In a foreclosure sale (a forced sale by operation of law) or short sale (sale by the owner with permission by the lender for less than the mortgage indebtedness), the sale proceeds used to satisfy the mortgage debt are generally clear; only the amount of the mortgage debt satisfied may be considered when part of the sale price is allocated to late penalties and interest.

To complicate matters, there is some authority in the Internal Revenue Code to treat the proceeds in a sale in which the mortgage lender participates as capital gain that can be sheltered by the generous $250,000/$500,000 Code Sec. 121 home sale exclusion.

In a deed-in-lieu-of-foreclosure situation, the market value of the residence at the time the deed is transferred to the lender, rather than a definite selling price, determines the amount of indebtedness income that may be forgiven. Since the lender has no particular incentive to value the property precisely, the homeowner should be vigilant in discussing this with the lender before the Form 1099-C is sent to agree on a fair value.

This concern is particularly important when a vacation or other second home is involved, since only a principal residence is covered by the new Sec. 108 exclusion. Even when a principal residence is involved, however, tax may result in improper valuation if forgiven debt in part involved nonqualified principal residence indebtedness.

In addition, a lender may not always be willing to forgive debt initially. A mortgage note is a personal obligation, although in some jurisdictions the lender for all practical purposes is limited to the value of the property for recovery of the debt. If a lender decides to pursue a homeowner after a foreclosure sale for the balance of the debt, no income is realized until the debt is no longer pursued. Reference to whether the lender issues a Form 1099-C may be particularly useful.

BASIS REDUCTION

The basis reduction required for any amount of forgiven-indebtedness income excluded under Code Section 108 takes different paths depending upon the type of exclusion.

If income is excluded because of insolvency at the time of forgiveness, then basis in the home must be reduced at the beginning of the next tax year. That basis reduction is treated as depreciation for purposes of recognizing any gain on a subsequent sale. As such, the amount of basis reduction must be recaptured at the 25 percent rate, and is not sheltered by any available Section 121 homesale exclusion ($250,000, except $500,000 for joint filers).

In contrast, if indebtedness income is excluded under the new principal residence exclusion, it reduces the basis in the home immediately but, since the basis reduction is required under Section 108(d) and not Section 1017, no ordinary income recapture of gain as the result of the basis reduction is required, and a full homesale exclusion is allowed to cover it.

LOSS NETTING?

Unresolved for at least a portion of the tax practitioner population is the allowance of any loss on the sale of a residence to offset any gain otherwise recognized on the forgiveness of mortgage indebtedness to which the property has been subject.

While the excess of mortgage debt over home value is forgiveness-of-indebtedness income, the IRS considers the loss realized on the home in selling it for less than was paid for it nondeductible as a personal loss under Code Sec. 162(c). Therefore, the generally accepted rule -- and one followed by the IRS -- is that a loss from the sale leg of the foreclosure cannot offset the income from the cancellation-of-indebtedness leg.

However, an old Supreme Court case may give new life to the argument that the debt forgiveness and sale should be considered as a whole. Specifically, the Supreme Court case of Kerbeugh-Empire, 271 US 170 (1926) has been given some press lately as a revitalization of the collapsed approach advocated in that case. The basic argument for resurrecting the Supreme Court case of Kerbeugh-Empire is that the loss on the sale of the home securing the mortgage is due to market forces, rather than to personal consumption, and therefore non-deductibility under authority of Code Sec. 162(c) is inapplicable.

CONCLUSION

The new income exclusion of certain forgiveness of mortgage indebtedness for principal-residence homeowners creates an escape valve for some at a time during which they need it most. Qualifying for this special treatment, however, requires meeting certain homeowner and debtor profiles for which advance planning can help.

While many homeowners are immediately assisted by the Mortgage Forgiveness Debt Relief Act, others should consider steps that may be taken to qualify: meeting principal-residence criteria, qualifying for acquisition indebtedness, and maximizing use of the homesale gain exclusion on the quick or eventual sale of the residence. These steps can help turn a bad situation to one at least in part balanced by some favorable tax breaks.

George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.

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