From the U-T:
WASHINGTON — With the Obama administration and private lenders now actively considering mortgage principal-reduction programs to help financially distressed homeowners, the Internal Revenue Service has issued a new advisory to taxpayers who receive — or seek to receive — such assistance if it’s offered.
The IRS gets involved in mortgage principal write-downs because the federal tax code generally treats any forgiveness of debt by a creditor in excess of $600 as ordinary taxable income to the recipient.
However, under legislation that took effect in 2007, certain home mortgage debt cancellations — such as through loan modifications, short sales or foreclosures — may be exempted from tax treatment as income.
Sheila C. Bair, chairman of the Federal Deposit Insurance Corp., recently confirmed that her agency is working on a new program to expand the use of principal mortgage reductions to keep underwater borrowers out of foreclosure. Major banks and mortgage companies have preferred monthly payment reductions and other loan modification techniques over cuts of principal balances, but a handful have made limited use of the concept.
One of the largest servicers of subprime home loans, Ocwen Financial Services of West Palm Beach, Fla., has strongly advocated principal reductions to keep people out of foreclosure, and claimed broad success with them. Ron Faris, president of Ocwen, testified to a congressional subcommittee earlier this month that borrowers with negative equity are as much as twice as likely to re-default after a standard, payment-reduction loan modification than those who receive partial forgiveness on their principal debt.
But what are the tax implications when your lender essentially says: OK, we recognize you’re underwater, maybe you’re thinking about walking away, and we’re going to write off some of what you owe to keep you in the house? IRS guidance issued March 4 spelled out step by step how financially troubled and underwater borrowers can qualify for tax relief when a lender agrees to lower their debt.
Here are the basics, should you be considering a short sale or loan modification involving principal reduction. To begin with, be aware that the federal tax exclusion only applies to mortgage balances on your principal residence — your main home — and not on second homes, rental real estate or business property. The maximum amount of forgiven debt eligible under the law is $2 million for married taxpayers filing jointly and $1 million for single filers.
But there are some potential snares: Your debt reduction can only be for loan amounts that you’ve used to “buy, build or substantially improve your principal residence.” This includes refinancings that increased your total mortgage debt attributable to renovations and capital improvements of your house. But if you used the proceeds for other personal purposes, such as to pay off credit card bills, buy cars or invest in stocks, the mortgage debt attributable to those expenditures is not eligible for tax exclusion.
Say you refinanced and used some of the proceeds to purchase a boat and pay off business debts. Those expenditures would not qualify for the tax relief provisions because they were not intended to substantially improve your house or build a residence. In all refinancings, make sure you can document where the money flowed.
When your lender formally forgives all or part of your mortgage balance, the lender is required by law to issue you an IRS Form 1099-C, a “Cancellation of Debt” notice, which is also sent to the IRS. The form shows not only the amount of debt discharged but the estimated fair market value of the house securing the debt as well.
A few other noteworthy features of the IRS rules: If you’ve been foreclosed upon or you do a short sale and you lose money in the process, don’t claim a tax loss on your federal filing. The IRS will turn you down. However, if you go to foreclosure and your lender agrees to cancel all or part of the unpaid mortgage balance as part of the deal, then you CAN file for an exemption from the IRS.
What if your lender reduces the debt on your house but you continue to own the property and live in it? There’s a tax wrinkle in the fine print: The IRS will require you to reduce your “basis” in the house — your “cost” for tax purposes — by the amount of the forgiven debt. But that’s not likely a big concern for most homeowners digging their way out of the bust.
Finally, if you want to claim the debt forgiveness exemption, download IRS Form 982 (available at www.irs.gov) and attach it to your return for the year in which the debt was forgiven. And don’t assume this tax code benefit to homeowners will be around forever. It expires at the end of 2012.
The fact that the IRS has taken steps to spell out these details is an ominous sign that massive and widespread principal reductions are coming and they are to be funded by the taxpayer.
All these laws, regulations, and proposals are causing many people to do nothing except pay their mortgage as agreed. I really think that is what they want us to do while the housing market recovers the next 3 – 5 years.
Note how important the book value of the home is.
If they are handing out principal reductions they better be prepared to hand me one. I’ll take a kitchen remodel in place of, however.
Just to rant a bit:
Seriously, how do we justify giving all this money away? No one was forced to buy at the peak. No one was forced to finance 80-100% of their house so that when the market went down they had no equity.
What I do think makes sense is allowing people to refinance from some crazy loan to a 30 year fixed and waving the equity requirements as long as they have the income to cover the payments. Other than that it seems to me we’re just giving away money to the unlucky and the irresponsible.
And bailing out the banks doesn’t justify principal reduction either. Two wrongs don’t make a right (but three lefts do).
End of rant . . .
I’d like to add to the prior rant(s).
If Congress wants to change the tax code to allow persons to write off losses on residential RE (their primary residence), then at least there is some “fairness” to this madness. But this “no tax” only on the “lost” borrowings, and not the lost savings only rewards the worst ones of the bunch: The 100% financers. People who saved their after-tax earnings in order to pay cash or make a down payment get no tax relief on their losses.
Perhaps the government thinking (oxymoron) is that those most irresponsible with money have no concept of paying taxes in any event, and hitting them with a tax bill is pointless because they have no $$ to pay said taxes.
OK. I’ll pass the rant baton to the next commenter …
Could our tax system be more broken?
Remember those home-builders who were ‘long and wrong’ on land and development? They got a bailout when you weren’t looking
http://www.calculatedriskblog.com/2010/03/home-builders-23-billion-gift-from.html
I have to agree with “Waiting to feel the magic” and “Smithers”. Where is the equity and fairness for those of us who lived financially responsibly and within our means? Why should those who gamed the system be taken care of while the rest of us are screwed? It’s enough that my wife and I work to support our own family. why should we support someone else?
This were just like another class graded by curve. Those studied hard with numerous sleepless nights get B and A. Those originally received D and F all get pushed up to B or better because the college cannot have anyone fails.
The lunacy in all of this is that if COD income did exist, we would have many fewer “stategic defaulters”.
My recollection is that there was always a hardship exception for COD income, but when the Bush administration started feeling sorry for people who weren’t necessarily bankrupt and still losing their homes and granted amnesty, they literally opened the floodgate doors.
Think about. A couple in CA making 100K/year say has a 9% state tax and a 22% federal tax on income above the 100K theshhold. If they have a 100K COD income, they will get a nice fat tax bill for 31K. They would think twice about “letting the bank take it”. Even if they didn’t think twice, they pay a big chunk out of the mess that they created.
Bring COD income back (except for real hardship–ie. force the homeowner to file BK and really get no credit). Either the homeowner really thinks twice about the default or they pay a nice chunk of the mess they create. Either way, it helps the situation instead of hurting it.
Add me to the those agreeing with Smithers and Waiting to Feel the Magic.
They are rewarding the worst of the lot, and punishing the most responsible. These are very bad moves, and I don’t think they fully understand the potential consequenses (though it should be obvious).
Homeowners were not responsible for the real estate bubble and bought in good faith at the going rate at that time. Sick of all those, “I don’t have a problem, so no one else should and we should help no one”. People like that are just lucky because they didn’t buy a home at the wrong time. They would have a different opinion if they were underwater, since they have no real philosophies, but just fickle opinions that change with their own self interest. Bail out the upside down homeowners, and take the money from the people who oppose it.