Reflections on the Mortgage Forgiveness Debt Relief Act of 2007
Kim Stanley
Introduction
The hot topic in the area of residential finance is the recently passed federal legislation eliminating taxation of the imputed gain realized by homeowners, struggling to avoid foreclosure, on the forgiveness of their mortgage debt. We asked our tax expert, Kim Stanley, director of the Tax LLM Program at Golden Gate School of Law, to look into the nuances of the new statute.-RB
Under long-standing tax principles, when a taxpayer receives loan proceeds, it does not realize taxable income because it has a corresponding offsetting obligation to repay the loan. When that obligation to repay is cancelled or forgiven, however, the taxpayer generally must report the cancelled debt as taxable income. IRC §61(a)(12). There are several exceptions to this general rule in IRC §108-for example, a taxpayer who is in bankruptcy or is insolvent at the time the debt is discharged generally may exclude the discharged debt from taxable income.
The Mortgage Forgiveness Debt Relief Act of 2007
With home foreclosures on the rise and fears of a recession looming, Congress acted quickly last fall to create another exception to §108. Now, taxpayers may exclude discharge of indebtedness income on loans that were used to acquire a principal residence even if they were not insolvent or in bankruptcy at the time of the debt discharge. The Mortgage Forgiveness Debt Relief Act of 2007 (Pub L 110-142, 121 Stat 1803) (the Act), signed into law last December 20th, applies to any discharge of "qualified principal residence indebtedness" occurring after January 1, 2007, and before January 1, 2010. "Qualified principal residence indebtedness" is debt that the taxpayer took out to buy, build, or substantially improve a principal residence and that is secured by the personal residence. It also includes refinanced mortgages on a principal residence up to the amount of the old mortgage principal prior to the refinancing. IRC §108(h)(2).
A taxpayer's principal residence is the home where the taxpayer ordinarily lives most of the time. IRC §108(h)(5). To be considered a principal residence, the owner must have lived in the home for any 2 of the past 5 years; the owner can have only one principal residence at any one time. Accordingly, debt relief obtained for mortgages on second homes, vacation homes, and business or investment property is not excluded under the new law.
The new exclusion is limited to $2 million of discharged debt for married taxpayers filing a joint return and $1 million for all other taxpayers (single, head of household, and married taxpayers filing a separate return). IRC §108(h)(2). If a loan is discharged and only part of it is "qualified principal residence indebtedness," then the exclusion applies only to the extent that the discharged amount exceeds the portion of the loan (before the discharge) that is not qualified principal residence indebtedness. IRC §108(h)(4). For example, assume the taxpayer's principal residence is secured by a $500,000 debt of which $450,000 is qualified principal residence indebtedness because the taxpayer used $50,000 of the loan proceeds to pay for his son's college expenses. If the lender takes back the property when it is valued at $400,000 and discharges the remaining $100,000 of debt, only $50,000 of the discharged debt may be excluded under the Act. Of the $100,000 debt that was discharged, $50,000 pertains to nonqualified debt (i.e., the proceeds that were used to pay for college expenses) and so is not excludable from income under the new provision.
The only downside of the new rule: The taxpayer must reduce his basis in his principal residence by the amount of the excluded discharged debt, which may increase the gain realized on the sale or other disposition of the property. IRC §108(h)(1). However, this may not be an issue for many homeowners because of the tax code's already generous exclusion of up to $500,000 of gain on the sale of a principal residence under IRC §121. In addition, the rule does not apply if the loan was discharged because the taxpayer performed services for the lender or on account of "any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer." IRC §108(h)(3).
To claim the exclusion, taxpayers must file IRS Form 982-Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) with their tax return for the year the debt was discharged.
Does the New Law Help Californians?
California law has not yet conformed to the new federal law, so any discharge of indebtedness income excluded under the law must be included in California taxable income. On January 7, 2008, however, SB 1055 was introduced (proposed Rev & T C §17144.5), which would adopt the exclusion for California tax purposes. If passed, this legislation would give California taxpayers a false sense of security, however.
In California, purchase money home loans are considered nonrecourse because lenders are prohibited from seeking a deficiency judgment against the borrower after a foreclosure sale of real property that secures a purchase money loan. CCP §580. A loan is nonrecourse if the lender's only remedy in case of default is to repossess the secured property (because the lender cannot reach the borrower's other assets to satisfy any shortfall). Under these circumstances, the unpaid principal balance of the mortgage is not seen as being "forgiven" or "cancelled" and does not cause the borrower to have cancellation of indebtedness income. Treas Reg §1.1001-2(a)(4)(i) and (c), Examples 7-8; IRS Letter Ruling 9302001. Thus, even if the Act were adopted as California law, it would not apply to those homeowners who had used purchase money indebtedness to acquire or substantially improve a principal residence. Such homeowners would not have cancellation of indebtedness income to exclude because their loans were considered nonrecourse in the first place.
The problem arises, however, when a taxpayer refinances an original purchase money mortgage and uses the "refi" proceeds for purposes other than (or in addition to) the acquisition or substantial improvement of the principal residence. Most lenders believe that any refinancing of a home mortgage removes the "purchase money mortgage" protection under California law and results in recourse liability against the borrower. Although this remains unclear, if such is the case, then debt discharged on a refinanced home mortgage would cause a California borrower to have cancellation of indebtedness income that might be excluded under the Act. Furthermore, to the extent a borrower has pulled out cash from a refinanced mortgage and used it, say, to pay off credit cards or other debts, the loan obligation is recourse under California law. But in that case, if part of the loan is discharged or forgiven by the lender, the borrower will have cancellation of indebtedness income that is not excluded under the new law because it was not used as "acquisition indebtedness." This is a trap for the unwary, and will require taxpayers and their advisors to keep accurate records of all home loan borrowings and the use of such proceeds.
Ancillary Provisions of the Act
Finally, there are four other new provisions of the Act of interest to real estate professionals, although these provisions are not part of the conformity legislation in SB 1055 and have not otherwise been enacted as California law. These provisions include:
- The Act extends to 2010 the tax deduction for mortgage insurance premiums paid in connection with acquisition indebtedness. The deduction begins phasing out for taxpayers with adjusted gross income exceeding $100,000 and is eliminated for AGIs over $110,000. Act §3, amending IRC §163(h)(3)(E).
- The Act establishes three alternative tests for qualifying as a cooperative housing corporation, amending IRC §216(b)(1)(D). The corporation will qualify if:
- 80 percent or more of the corporation's gross income for the year is derived from tenant-stockholders;
- 80 percent or more of the total square footage of the corporation's property is used or available for use by the tenant-stockholders for residential purposes (or purposes ancillary to residential use); or
- 90 percent or more of the housing corporation's expenditures are for acquiring, constructing, managing, maintaining, or caring for its property for the benefit of its tenant-stockholders. Act §4.
- The Act amends IRC §42(i)(3)(D) to expand eligibility for the low-income housing tax credit to include units that are occupied by full-time students who are single parents and their children, as long as neither the parent nor the children are claimed as dependents of another individual. Act §6.
- The Act amends IRC §121(b) to allow a surviving spouse to exclude up to $500,000, rather than the $250,000 provided to single taxpayers, on the sale or exchange of a principal residence owned jointly with the deceased spouse. The sale must occur not later than two years after the death of the deceased spouse and the other ownership and use requirements apply. Act §7.
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