Mortgage Measure Moves

Relief from tax in foreclosure, plus other provisions

By Kaye A. Thomas
Posted December 21, 2007
Updated February 4, 2008

Relief applies retroactively to 2007.

One of the last measures passed by Congress in 2007 was the Mortgage Forgiveness Debt Relief Act of 2007. The main purpose from this law is to protect people from having to pay tax as a result of a mortgage foreclosure.

It may seem strange that this would even be an issue. Why hit someone with tax when they lost their home? The answer has to do with something called cancellation of debt income, or COD for short.

When you take out a loan you acquire money from the lender, but you don't report any income because you have an obligation to repay the loan. If the lender cancels the debt before you pay off the loan, though, you've been enriched by having received money you're no longer obligated to repay. That's the theory, anyway.

When a lender forecloses on a mortgage, proceeds from selling the property may not be enough to pay off the loan. Cancellation of the remaining debt will be reported to the IRS as COD income. Existing rules provide some exceptions: you don't pay tax when debt is cancelled in bankruptcy, for example, or when your net worth remains zero or negative even after the debt cancellation. But homeowners can end up in foreclosure without being able to qualify for these exceptions. Having to pay additional tax in this situation adds insult to injury.

Who's affected

The new law provides relief to taxpayers who meet certain requirements.

The discharge of indebtedness has to occur on or after January 1, 2007. People that had debt cancelled in foreclosure before 2007 must rely on existing exceptions or, if they don't qualify, pay the tax.
The discharge has to occur before January 1, 2010. An earlier version of the law would have created a permanent exception but the final version expires after 2009, in accordance with President Bush's wish.
The debt has to be incurred in the acquisition, construction or substantial improvement of the home. In other words, if you took out a home equity loan for a purpose other than home improvement, this relief isn't available.
The home has to be your principal residence. Relief isn't available if the loan was used to buy a property for rental or investment, or a second home.
You have to owe no more than $2,000,000 on the home ($1,000,000 if married filing separately).
Relief isn't available if debt was discharged in exchange for services you provided to the lender.

If you qualify for this relief, the amount excluded from income will reduce your basis in the home. This won't matter except in a situation where you ended up with an overall profit after the foreclosure sale. Even then, you may avoid tax because of a rule allowing people that meet certain requirements to exclude up to $250,000 of gain from the sale of a principal residence. But if you don't qualify for the $250,000 exclusion, or your gain exceeds the amount you can exclude, this basis adjustment can result in additional tax. The additional tax is likely to be smaller than if you had to report COD income, however.

Other provisions

The new law includes some other tax benefits. One extends for three years, through the end of 2010, an existing rule that allows certain homeowners to treat mortgage insurance premiums as interest, making them eligible to be claimed as an itemized deduction. Another allows a surviving spouse to exclude up to $500,000 of gain on the sale of a home (the amount that applies to married couples) if the sale occurs within two years after the death of a spouse.

The final version of this law does not include a change appearing in an earlier version that would have limited the tax benefit of converting a vacation home to a primary residence. Instead, this law offsets the revenue loss from the tax relief mainly by modifying penalties for failure to file partnership and S corporation tax returns.

Update

The IRS has issued a revised version of Form 982, which can be used to report the exclusion of this item of income (see line 1e).