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Gross Income Exclusion for the Discharge of Indebtedness on Principal Residences

December 01, 2011

Laura L. House, CPA
Tax Manager
BlumShapiro

For most of the U.S., 2007 marked the beginning of the financial crisis and the rapid decline in the U.S. real estate market.  During the first half of the decade, the lending market had begun issuing riskier mortgages with adjustable interest rates to individuals who could not qualify for conventional mortgages. The ease in which homeowners were able to secure these loans caused a greater demand for home ownership, and home builders were constructing new houses quickly to capitalize on the high demand.

These subprime, high-risk mortgages were financed with loans with lower interest rates and mortgage-backed securities.   There were a disproportionately high number of these mortgages in existence and financial institutions were investing heavily in them.  Since the beginning of the financial crisis, financial institutions have been widely criticized for failing to exercise due diligence in evaluating and balancing the risks associated with these investments and have been targeted as one of the largest contributors to the instability of the U.S. economy. 

Rising interest rates caused many homeowners to default on their adjustable rate mortgages. The increased number of foreclosures along with the abundance of newly constructed houses produced an excess supply of homes, and housing prices began to decline as a result. Many homeowners were trapped with high-rate mortgages and the inability to refinance due to the decline in their homes' market value. Major global financial institutions suffered greatly due to their significant investment in what became worthless mortgage-backed securities.  Concerns about the stability of the U.S. credit and financial systems led to stricter credit practices around the world and caused global investors to reduce their investment in the U.S. economy.  

Mortgage Forgiveness Debt Relief Act of 2007

As a result of the subprime mortgage crisis, the Mortgage Forgiveness Debt Relief Act of 2007 ("The Debt Relief Act") was passed to provide some relief to homeowners who fell victim to adjustable rate mortgages and the lending practices of large U.S. financial institutions.  The Debt Relief Act was later extended by the Emergency Economic Stabilization Act of 2008.  The Debt Relief Act provided an exception to the general rule under IRC Sec 61(a)(12) that requires the discharge of indebtedness to be included in a taxpayer's gross income.  Discharge of indebtedness income is the difference between the outstanding loan balance prior to discharge and the amount paid to satisfy the debt.  Prior to the passing of the Debt Relief Act, a taxpayer could only exclude debt discharge income from his gross taxable income if the taxpayer filed bankruptcy under Chapter 11 or when the taxpayer was insolvent.  The Debt Relief Act added IRC Sec 108(a)(1)(E) which states that "qualified principal residence indebtedness" discharged after 2006 and before January 1, 2013 is precluded from a taxpayer's gross income.  The income exclusion is limited to $2 million for a couple filing a joint income tax return and $1 million for a single filer.

To determine if the forgiven debt is deemed "qualified principal residence indebtedness", taxpayers must refer to the definition of "acquisition indebtedness" provided by IRC Sec 163(h)(3)(B).  Acquisition indebtedness is defined as indebtedness that is incurred in acquiring, constructing or substantially improving any qualified residence which is also secured by the residence.  The definition is extended to include refinanced debt as long as the refinanced loan amount does not exceed the original loan amount.  Therefore, the mortgage forgiveness exclusion under Sec 108(a)(1)(E) does not apply to discharges of second mortgages or home equity loans unless the loan proceeds were used to acquire, construct or substantially improve the taxpayer's principal residence. 

For purposes of Sec 108(a)(1)(E), a person's "qualified residence" refers only to the taxpayer's principal residence and not to second homes, vacation homes, business or investment properties. A taxpayer's principal residence has the same meaning as used in IRC Sec 121.  For a residence to qualify as a principal residence under IRC Sec 121, the taxpayer must own and use the residence for two of the five years preceding the sale by the taxpayer.  For a married couple, the usage requirement must be met by both spouses but only one of the spouses needs to meet the two-year ownership requirement for it to qualify as a principal residence.

The mortgage forgiveness income exclusion does not apply if the debt discharge was granted because of services that were performed for the lender or any other factor that is not directly related to a decline in the value of the principal residence or the taxpayer's financial condition.

When qualified principal residence indebtedness income is excluded from the taxpayer's gross income under Sec 108(a)(1)(E) and the taxpayer continues to own the home after the debt discharge, the taxpayer's basis in the residence must be reduced, but not below zero, by the income exclusion amount (i.e. the debt discharged).  A taxpayer must file Form 982 with his income tax return to disclose the amount of income being excluded under Sec 108(a)(1)(E) and also to reflect the reduction in the taxpayer's basis in the residence after the discharge. The income exclusion applies only to the debt discharged and does not have any effect on the income or loss recognition on the actual or deemed sale of the principal residence upon foreclosure or repossession. 

Foreclosures & Repossessions

When a lender forecloses on a loan or repossesses the property, the foreclosure or repossession is treated as a sale of exchange from which the debtor may realize a gain or loss on the sale.  The tax consequences of loan foreclosures and property repossessions can differ depending on whether the acquisition indebtedness is recourse or non-recourse debt. 

Recourse debt allows the debtor to be held personally liable for the loan balance in the event of a loan default.  Conversely, a non-recourse debt allows creditors only to take possession of the property secured by the loan and not to seek remuneration from the debtor even if the fair market value of the property is less than the outstanding loan balance.   

In the event of a foreclosure on a qualified principal residence with a non-recourse mortgage, the lender is treated as having sold the property for the full amount of the remaining debt balance.  Therefore, the amount of the cancelled debt is reported as the total gross proceeds from the deemed sale even if the property was subsequently sold for less.  The gain or loss is the difference between the outstanding loan balance upon foreclosure/repossession and the debtor's adjusted basis in the property.

Example 1Taxpayer A defaults on a $280,000 non-recourse loan used to purchase his principal residence three years ago.  At the time the bank foreclosed on the loan, the property had a fair market value of $275,000.  The taxpayer purchased the home for $300,000. 

The property is treated as sold for $280,000, the balance of the non-recourse debt.  The taxpayer has a $20,000 non-deductible personal loss on the sale which is the difference between the deemed proceeds and his adjusted basis in the property ($280,000 - $300,000). Because the full amount of the discharged debt is recorded as proceeds from the sale, there is no discharge of indebtedness income to recognize.

When the lender forecloses on a recourse loan and repossesses the property, the amount of the cancelled debt does not necessarily represent the proceeds from the sale or exchange.  If the fair market value of the property is less than the cancelled debt, then the proceeds are deemed to be the amount of the cancelled debt up to the fair market value of the property.  In this situation, the debtor has debt cancellation income for the difference between the cancelled debt and the FMV of the property.  The income from the discharge of indebtedness is excludible from gross income under 108(a)(1)(E) if it meets the definition of qualified principal acquisition indebtedness income. 

Example 2Taxpayer B defaults on a $280,000 recourse loan used to purchase his principal residence three years ago.  At the time the bank foreclosed on the loan, the property had a fair market value of $275,000.  The taxpayer purchased the home for $300,000. 

The property is treated as sold for $275,000, the amount of the cancelled debt up to the property's FMV.  The taxpayer has a $25,000 non-deductible personal loss on the sale for the difference between the deemed proceeds and his adjusted basis in the property ($275,000 - $300,000).  In addition, the taxpayer has qualified principal residence indebtedness income for $5,000, the difference between the cancelled debt and the fair market value of the property upon foreclosure.  The $5,000 of debt discharge income is excludible from the taxpayer's gross income under IRC Sec 108(a)(1)(E) because it qualifies as principal acquisition indebtedness income.

To the extent that there is a gain on the sale, all or part of the gain may be excludible from gross income under IRC Sec 121 home-sale rules, but the gain does not qualify for exclusion under IRC Sec 108.

Before the Mortgage Forgiveness Debt Relief Act of 2007 there was no income exclusion for the discharge of qualified principal residence indebtedness.  Therefore, solvent homeowners with recourse mortgages would be forced to recognize cancellation of indebtedness income without being able to offset the income with the loss on the sale because the deemed sale transaction resulted in a non-deductible personal loss.  The passing of the Debt Relief Act has alleviated this inequitable tax treatment. 

Planning Opportunities

There are more planning opportunities that exist when dealing with non-recourse mortgages as opposed to recourse mortgages.  In some instances, it may be more advantageous from a pure tax perspective to default on a non-recourse mortgage than it would be to stay in the home.  This is particularly true if your non-recourse mortgage does not qualify as home acquisition debt.

Example 3:  Taxpayer C borrows against the equity in his principle residence.  The bank gives him a non-recourse loan in the amount of $500,000.  The loan is not considered home acquisition debt.  The taxpayer originally purchased the home for $550,000.  The fair market value of the house is $400,000.

If the lender agrees to discharge $100,000 of the $500,000 non-recourse debt, the taxpayer will have $100,000 of cancellation of indebtedness income to include in his gross income.  The income is not excludible under IRC 108(a)(1)(E) because the debt is not qualified principal residence indebtedness. 

If the taxpayer defaults on the $500,000 non-recourse loan and the property is repossessed by the lender, there is no tax consequence.  The foreclosure is treated as a sale. The proceeds from the sale are $500,000 which is equal to the amount of the debt discharged.  The taxpayer's basis in the property is $550,000.  Foreclosing on the property results in no cancellation of indebtedness income and a $50,000 non-deductible tax loss.

Clearly there are other personal considerations an individual contemplates in determining how to manage or absolve himself of a mortgage that he is no longer able to afford.  Whether the solution is to negotiate with the lender for a lower interest rate, to request a discharge from all or part of the debt or to default on the loan, it is imperative that the debtor understand the tax consequences associated with each of these alternatives.  

 

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