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Is Mortgage Debt That Is Discharged Taxable As Ordinary Income

This topic is a real bugaboo that seems to be attracting quite a bit of attention these days, what with foreclosures, short sales, bankruptcies and walk-aways in full bloom in the garden known as the mortgage meltdown. Unfortunately, there seems to be more misinformation and urban myth floating around than good professional advice. If you have any reservations at all about your status, don’t make any assumptions about this subject without consulting a lawyer or accountant.
The short answer is that Congress did pass the Mortgage Forgiveness Debt Relief Act of 2007, which does provide a lot of relief, and will probably benefit most of the folks that are most in need of the relief it provides. But if you have investment property or a HELOC, keep reading.
First of all, the general rule is that forgiven debt gives rise to “ordinary income” which is a taxable event ordinarily reported on IRS Form 1099. Historically, there has been an exception that if the taxpayer is insolvent (which means only that their debts exceed their assets) then the forgiven debt is not taxable to the extent of the insolvency. This means simply that if I owe $100 but my assets are only $80, then I am “insolvent” to the measurable tune of $20, and the amount of the forgiven debt that is not taxable would be limited to that $20. The filing of a bankruptcy petition gives rise to a “presumption of insolvency” which usually is the end of the issue and the taxpayer won’t be taxed on the forgiven debt. Absent a bankruptcy petition, you would normally have to prove the insolvency to the IRS in order to avoid the tax.
Last year Congress passed H.R. 3648, the Mortgage Forgiveness Debt Relief Act of 2007. This statute, which is a change to the Federal tax code, creates a specific carve out to the general rule without requiring the taxpayer to prove insolvency or go through the bothersome chore of filing bankruptcy. But it is not the free ride that some news sources and pundit-sorts have made it out to be.
First, the real property securing the forgiven debt must be the taxpayer’s principal residence, which means that the taxpayer had to have resided in it as a principal residence for the prior two years. A taxpayer can only have one principal residence. Second homes, vacation homes, investment property and raw land do not qualify. While this won’t disqualify the mass of folks currently awash in the foreclosure paper chase from sea to shining sea, it means that this is not a safe harbor for investors.
Second, the amount is limited to $2 million. Not a huge obstacle in most parts of the country, but with real estate prices in the Bay Area being what they are, this limit could still hit some poor soon-to-be-homeless gazillionaire where it hurts.
Third, the window is only open for three years. The debt must be discharged between January 1, 2007 and January 1, 2010, unless extended before then. So if you’re going to lose your home, you better hurry!
Fourth, the debt canceled must be a loan that was used to “acquire, construct or substantially improve” the property. Sounds innocent enough, but this will exclude many home equity loans and probably all home equity lines of credit. Given that a lot of the loans that are causing the most pain right now are second deeds of trust that might not have been purchase money loans, this limitation could catch a lot of folks looking in the wrong direction. If the loan that is about to adjust up and double the monthly payment on that second you took out to pay down some college tuition or credit card debt, this law won’t help you.
While the IRS hasn’t yet published one of its riveting standard publications yet–the law only went into effect January 1, 2008–you can still get their current spin on the law’s provisions here. This is the bookmark publication until something more formal is issued.

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