The Mortgage Debt Forgiveness Debt Relief Act of 2007

The basic way we make money as real estate investors is buying at a low price and selling for a higher price (for flips) or buying cheaply so you can have a low mortgage and renting the property at a profit. This is the same way a store makes money – the store buys at wholesale and sells at retail. To stock our real estate store we need to find houses we can buy at a wholesale price. As a real estate investor you will run into homeowners who want to sell you their property but the property is over-encumbered with debt. Often the homeowner owes more than the property is worth! If you pay a wholesale price the homeowner will not be able to pay off the mortgage(s) and thus it would appear there is no deal to be made. There is a technique that fixes this problem – the Short Sale.

A short sale is when the lender accepts less than the full amount owed but still releases the property from the mortgage. This creates a profit spread for the investor. For example, if you reached an agreement with the owner of a $200,000 retail property to sell the property to you for a wholesale price of $150,000, you would then approach the bank with a copy of the agreement of sale (and other papers we will not go into here) proposing that in exchange for releasing the property from the mortgage the lender accept the net the seller would have received from the sale (which would be equal to $150,000 less the transaction costs including real estate commissions, transfer taxes, etc.).

Lenders will sometimes accept a short sale because they recover more money through the short sale than they would recover if they complete the foreclosure. This is because the bank has to spend a lot of money to foreclose – paying attorneys, trustees, sheriffs, process servers, etc. Typically by the time the lender forecloses they end up recovering about 60% of the total amount they are owed. To make matters worse they receive that money when the property is resold. That is often many months after the homeowner stops paying on the mortgage. Sometimes it is even more than a year!

The short sale can be a win for everyone – the homeowner gets out from under a mortgage he cannot afford to pay, the lender recovers more than if it had to foreclose, and you get a profitable deal. Its all great – until the tax man comes to kill your deal. The short sale can cause a significant tax bill for the homeowner. This is because of a concept called debt forgiveness. Just because the lender agreed to release the property from the mortgage it does not mean the homeowner does not still owe the bank the difference between what was owed and how much the bank accepted as part of the short sale. Sometimes the lender will give up ever collecting that money and will forgive the debt. They will then issue an IRS form 1099 to the homeowner. The 1099 reports the debt forgiven as taxable income to the homeowner. The good news is that the homeowner is now completely free of the debt owed the lender, the bad news is that under the IRS code there is more than likely a tax bill! It doesn’t make sense that a homeowner in financial distress requiring debt forgiveness could afford a high tax bill; but, tax code doesn’t always make sense.

This post will tell you about a tax law signed on December 20, 2007 that can eliminate taxes that would generally be due from the homeowner in the event of a short sale. The Mortgage Debt Forgiveness Debt Relief Act of 2007. When your home is losing value and your family is under financial stress, the last thing you need is to be hit with higher taxes.

On December 20, 2007 President Bush signed a new temporary law that temporarily amends the IRS code with creating a 3-year window to help homeowners avoid foreclosure by protecting the homeowner from higher taxes when they refinance or restructure their mortgages. The intention is that there will be increased incentive for borrowers and lenders to work together to refinance loans in an effort to allow homeowners to secure lower mortgage rates/payments without adverse tax consequence. Prior to the amendment, if a house declines in value and a bank or lender forgives a portion of your mortgage, the IRS treated the amount forgiven as income that can be taxed, making a bad situation for the homeowner worse.

In order to qualify for the exclusion from tax liability under the new law, the situation must meet several criteria:

• The debt forgiven must have been used to buy, build or substantially improve the principle residence and must be secured by that residence (not home equity loans or cash-out refinances if the money was not used to fix up the home); Debt used to refinance may also be eligible for exclusion, but only up to the amount of the old mortgage principle, just before financing.

• The property must be the primary residence of the homeowner (no second homes, investment properties, business property, credit card or car loans);

• The maximum amount of the debt is $2,000,000; $1,000,000 for married filing separate returns.

• The debt must be forgiven on or before December 31, 2009; and

• The debt forgiveness must be related to a decline in the value of the residence or the financial condition of the homeowner.

Homeowners who refinanced their personal residences may not be covered by the new law. When calculating the amount of forgiven debt that can be excluded from income, any debt not used to buy or improve the personal residence is considered cancellation of indebtedness income which is taxable. So if you refinanced your home for more than the original cost of the residence including improvements the difference is going to be taxable income.

The following is an example that illustrates this point:
Let’s assume a homeowner originally purchased their home for $300,000 and later made improvements totaling $45,000. Based upon this information, the homeowner has a tax basis in the residence equal to $345,000 (the original price of $300,000 plus improvements of $45,000). Let’s further assume the homeowner originally took out a mortgage of $240,000 and then later, when the value of the home appreciated, refinanced the property and took out a loan of $400,000. The homeowner used the $160,000 from the refinancing to pay off credit cards and buy a new car. About two years after the refinancing, the value of the residence declined and the lender agreed to a short sale of the property for $325,000, forgiving the additional $75,000 of debt. In this instance with the new legislation, the homeowner is going to have cancellation of indebtedness income equal to $30,000 ($75,000 less the $45,000 in improvements). If the forgiven debt cannot be associated with the purchase or improvement of the personal residence, the cancellation of debt income is taxable as ordinary income at the taxpayer’s marginal rate of taxation. Assuming in the above example the taxpayer was in the 28 percent federal tax bracket and lived in California with a 9.3 percent state tax rate, the taxpayer would have an additional tax liability of $11,190 ($30,000 multiplied by 37.3 percent) because the debt forgiven was used to pay off credit cards and buy a new car.

As a result of this new law, it is very important that homeowners who are facing foreclosure keep accurate records on the value of the improvements that they make to their residence. The value of these improvements can be used to offset cancellation of indebtedness income that is potentially taxable.  As stated earlier, a key aspect of the law is that the property must qualify as the taxpayers primary residence. Second homes, vacation homes, business and investment property are not included in the forgiveness. As a side note other types of debt forgiveness may qualify for exclusion from income under separate legislation or code. For instance there is an “insolvency” exclusion that normally relieves a taxpayer from including forgiven debts in income to the extent that the taxpayer is insolvent (when total liabilities exceed total assets). Additionally, exclusions exist under Title 11 bankruptcy, qualified farm indebtedness and qualified real property business indebtedness. However to qualify for mortgage debt forgiveness under the debt relief act of 2007, homeowners must meet both the ownership and use tests to qualify their home as a personal residence. This means that during the 5 year period ending on the date of the foreclosure or short sale, the homeowner must have:

• Owned the home for at least 2 years

• Lived in the home as their main home for at least two years.

You can meet the ownership and use tests during different two year periods. You must, however, meet both tests during the 5-year period ending on the date of foreclosure or short sale. Additionally, there are exceptions to the above rules for members of the uniformed services, foreign service employees and employees of the intelligence community as well as individuals with a disability. In addition to meeting the ownership tests, it is important to note how long the residence has qualified as a personal residence. Under the new law, the amount of the forgiven debt that qualifies to be excluded from income, reduces the basis of the personal residence. A reduction in basis, may mean an increase in capital gains tax. Capital gains income is calculated by subtracting the basis in the property from the sale price of the property. The difference
between the basis and sales price is subject to capital gains tax. Therefore, the forgiveness of debt, resulting in a reduction of basis, may create a capital gains tax that of which the homeowner may not be aware. As you may already know, there can be tremendous tax advantages when selling a personal residence. In fact, a homeowner can realize a gain of up to $250,000 to $500,000 completely tax-free if they have lived in the home for two of the last five years. If the reduction of the basis (due to forgiveness of debt) does not cause the gain to exceed the (up to) $250,000-$500,000 tax-free gain and the homeowner has met the requirements to receive the $250,000-$500,000 gain tax free, the reduction in basis is not likely a problem.

However, if the homeowner does not qualify to receive the gain up to $250,000-$500,000 because they have not met the requirements, then the reduction of basis could, in theory, create a capital gains tax issue for the homeowner. In the example above, if the homeowner owes $400,000 on the property and accepts a short sale for $325,000, there would be a $75,000 forgiveness of debt had the homeowner performed $75,000 of improvements. The $75,000 forgiveness of debt would reduce the basis in the property dollar for dollar. Therefore the basis in the property would be $300,000 ($300,000 purchase price plus $75,000 improvements less $75,000 of debt forgiven). The sale price of $325,000 results in a gain of $25,000 (sale price of $325,000 less basis of $300,000). If the homeowner has lived in the home for less than two years, they would not qualify to exclude the $25,000 gain and would therefore have to pay tax based upon that gain. It is just something to be aware of.

Under the new law, the maximum amount of the debt that can be cancelled before it becomes taxable is $2,000,000 for married taxpayers filing joint returns and $1,000,000 for single individuals and married taxpayers filing separate returns.
Taxpayers will use IRS Form 982 to report the short sale or foreclosure. However, please be aware that because of the timing of the passing of the bill, reporting procedures may not have been incorporated into tax-preparation software. Additionally, be sure to use the revised IRS form 982 to be sure everything is reported correctly. Borrowers whose debt is cancelled will
receive a year-end statement (Form 1099-C) from their lender. This form will show the amount of debt forgiven and the fair market value of any property given up through foreclosure. The homeowner will want to be sure to check the amounts shown on the form 1099-C for accuracy, otherwise they could experience problems. The law has lots more details and covers subjects not related to the short sale debt forgiveness. It is sufficiently complex that you need an accountant or tax specialist to make the final call over whether a homeowner’s situation will be taxable. That being said, if a homeowner has an objection to the short sale because of the debt forgiveness, if the situation is one where the homeowner is selling their primary residence, the debt is less than $2,000,000 and it is the mortgage used to purchase the property, you can tell the homeowner that under the law they will not have a tax bill if the lender forgives the debt.

Other Possible Ways to Avoid Taxation in Connection with a Short Sale Remember, if your homeowner does not qualify for the exclusion under the Mortgage Debt Forgiveness Debt Relief Act of 2007 there are some additional exceptions that can allow a homeowner to avoid tax – namely if the taxpayer is insolvent or bankrupt. Also, it is good to know that the act also extends (for 3 years) a tax deduction allowing families earning $109,000 or less per year to deduct all or part of their private mortgage insurance premiums—which could save them an average of $350.00 per year. Families who earn more than $109,000 per year, may be eligible for partial deductions.

Even though this program has just expired, investors can still take advantage of the many short sale opportunities that are still available. Build a Fortune With Real Estate Foreclosures and Short Sales. Real Estate Foreclosure Short Sale Course Reveals from beginning to end how to short sale a property. Often Advertised. Rarely Delivered.