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Forgiveness Act of 2007
 

Details of the Mortgage Forgiveness Debt Relief Act of 2007
 
 
                                                H.R. 3648
                              Mortgage Forgiveness Debt Relief
                                             Act of 2007

IMPORTANT NOTE:  THIS ACT ENDS DECEMBER 31, 2012 UNLESS OTHERWISE EXTENDED

Permanent exclusion from gross income of discharged home mortgage indebtedness. The bill would amend current law, which requires taxpayers to include discharges of mortgage indebtedness as income and to pay tax on this income. The bill would provide a permanent exclusion for discharges of up to two million dollars of indebtedness (on or after January 1,2007) which is secured by a principal residence and which is incurred in the acquisition, construction, or substantial improvement of the principal residence. Instead of including this amount as income, the basis of the individual’s principal residence would be reduced by the amount excluded from income under this bill. This proposal is estimated to cost approximately $1.4 billion over 10 years.
Long-term extension of the deduction for mortgage insurance. The bill extends the deduction for mortgage insurance for seven years (through the end of 2014). Current law limits the deduction for mortgage insurance to payments (including Veterans Administration, Rural housing Administration, and Federal Housing Administration insurance premiums) made prior to the end of 2007. The bill would provide that payments will qualify for this deduction whenever they are paid so long as the contract is entered into after 2006 and before 2015. This proposal is estimated to cost $570 million over the next 10 years.
Modification of the qualification tests for cooperative housing corporations. The bill would modify the requirements for qualifying for the special rules available to cooperative housing corporations. Under current law, a cooperative housing corporation must meet several requirements, including a requirement that 80 percent or more of the cooperative housing corporation is earned from the corporation’s tenant-stockholders. The bill would provide two alternatives to this 80 percent rule (i.e., one based on square footage and another based on cooperative expenditures). These two alternatives will make it easier to qualify as a cooperative housing corporation. This proposal is estimated to cost $22 million over 10 years.
Modification of exclusion of gain on sale of a principal residence. The bill amends the current law exclusion of up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. Under current law, the sale of a home will qualify for this exclusion if the home is a taxpayer’s principal residence for at least two of the five years ending on the sale or exchange. This exclusion applies even if the home was initially purchased as a second home. Under the bill, if a taxpayer moves their principal residence to a second home, the taxpayer will only be able to utilize this exclusion to the extent that it relates to the period of time when the home was first used as a principal residence. The bill grandfathers use before 2008. This proposal is estimated to raise $2.005 billion over 10 years.

Background

Prior to December of 2007 if a homeowner lost his house due to a bank foreclosure, and the bank forgave any difference between the price it was sold for and what was owed, the homeowner would owe additional income tax on that portion. Yes, it's hard to believe, but true.


Let's say the homeowner owed $300,000 on the mortgage, but the foreclosure sale only brought in $200,000. Then the bank forgave the $100,000 shortfall. The homeowner would have been liable for the income tax on the $100,000 debt forgiveness from the bank.

The IRS considered this money effectively paid to the homeowner, and it would be taxable in their top bracket. The special reporting form 1099-C depicts the explanation of this exactly - the "C" stands for cancellation of debt and the law said this was taxable income.

Now, because of the unique stresses in the housing industry lately and on our whole economy, last December Congress stepped in to provide temporary relief in the form of forgiving this debt, but only for the 2007, 2008 and 2009 tax years. After that, the old rule applies again.

Must be a Principal Residence

To be eligible for this tax relief, the mortgage must be for your principal residence. It does NOT apply to vacation, investment or other properties. And no more than $2,000,000 of forgiven debt can be excluded from taxable income. Well, most of us would fall below that threshold anyway.


Home Equity Loans

Another very important detail in this temporary tax break is if part of the forgiven debt was a home equity loan and used for purposes other than to build, buy or substantially improve the property, that portion is STILL taxable. In other words, home equity loans used for vacations aren't included.

Short Sales

Now, what happens in a short sale? In brief, this can occur when a borrower is behind on the mortgage payments and the lender agrees he can sell his house for less than what is owed on the mortgage. But all proceeds must be turned over to the bank.

The portion of the mortgage the bank forgives, PLUS any commission expenses or other selling costs ARE taxable income if this debt is canceled. Yes, even the commission and selling expenses count. No free rides. But, again for taxable years 2007, 2008 and 2009 Congress has provided the same temporary relief in this short sale situation.

A short sale is not always the answer. First, the bank must agree to it and generally will weigh the cost of the short sale against the cost of a foreclosure.

Other Things
There are situations where the bank sees a homeowner with a great credit history, but who is having trouble making mortgage payments for a legitimate reason. If the bank agrees to reduce the mortgage by say 25%, this is again considered a cancellation of debt and would have been subject to income tax. But for the above stated tax periods, this new, temporary tax provision forgives this income.

Why is there always a catch! If the homeowner does take advantage of debt cancellation by the lender, they are required, when they do eventually sell, to reduce the basis (original price of the home) equal to the amount forgiven.

What does that mean? A homeowner can now receive a $250,000 (single) and $500,000 (married) capital gain exclusion on the sale of their primary residence.
Here's an example where the home was originally purchased for $300,000, there was a $100,000 debt cancellation, and a married couple is selling the home:

Home Sells for $750,000
Less Original Basis* ($200,000)
Less Capital Gain Exclusion ($500,000)
Gain on Sale $50,000
Capital Gains Tax at 15% $7500 (Owed by homeowner)

*This is the original basis or price of home $300,000, less the $100,000 debt cancellation from the lender.

While $7500 capital gains tax is surely a lot less than the $100,000 cancelled by the lender, the homeowner may not think of this or be aware it could happen down the road, perhaps just prior to retirement. And capital gains taxes are always subject to change.

It gets a bit more complicated when one spouse dies and the other is left to sell the home. Consult your tax accountant or attorney for planning purposes.

Mortgage Insurance Affected

It is important to also note that this act extended mortgage insurance as an itemized deduction all the way through 2010. Yes, there's a restriction. The mortgage contract has to be entered into between December 31, 2006 and January 1, 2011.

Housing Market Stabilization

All of this is being done in an effort to stabilize our housing market and should help many homeowners in these situations. Always consult with a professional tax accountant or attorney to be sure you are taking the right road to solving your mortgage crisis and will be covered under this new tax relief act.

Other Thoughts

No matter the circumstances, there's a lot of stress a homeowner goes through in a foreclosure or a short sale. The loss of the home itself and any equity can add a lot of anguish to a situation that may be beyond the control of the homeowner from job loss or illness to changing market conditions.


 
 

 
Short Sale Information courtesy of REMAX Crossroads III (734) 699-4000

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