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.
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 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, 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 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.
But bear in mind that California treats real estate losses differently from the federal government. The Legislature is working on ways to conform state law to federal practice, but it is unclear when final action will take place .Here are the basics regarding federal tax law, should you be considering a short sale or loan modification involving principal reduction. To begin with, be aware that the 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.
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