Forgiveness Debt Relief Act of 2007 Reduces Negative Tax Consequences
Tom English and Bill Lathen
APRIL 2008 -
During the recent U.S. real estate boom, some lending institutions
abandoned all caution. Lending policies for subprime mortgages became
extremely lax. Dubious loans—such as the so-called “Ninja”
(no income, no job or assets) loans—became increasingly commonplace.
This may be why U.S. homeownership rose from 65% to 69% between
1996 and 2005 (www.census.gov/hhes/www/housing/hvs/qtr307/q307tab5.html).
values obscured otherwise bad loans. Now that the market has cooled
considerably and real estate values have plummeted, the result
has been a significant number of foreclosures and an international
credit slump. Some subprime lenders, such as New Century Financial,
have been driven to bankruptcy (www.ncen.com).
of these macroeconomic issues is that many subprime borrowers
have found themselves with a significant tax liability resulting
from the foreclosure on their residence. What follows is a description
of such a tax problem that has arisen from the subprime lending
and foreclosure issue. The authors detail current efforts to reduce
the number of foreclosures, as well as the legislation addressing
taxation issues in foreclosure. Finally, they offer suggestions
for tax planning.
Loans and the Foreclosure Problem
loans were created for potential borrowers with a low credit score,
generally in the low 600s or less. Subprime loans carry higher
interest rates and often have a prepayment penalty or balloon
payment. The rates are high because of normal credit considerations
such as credit score, size of down payment, and prior delinquencies.
Some loans include a “negative amortization” option,
which allows the borrower to pay less than the full amount of
interest, causing the loan balance to increase over time. There
are problems with adjustable rate mortgages (ARM), loans which
offer a low “teaser rate” that adjusts over time.
One common type of ARM is a hybrid ARM, which has a fixed rate
for a specified period and adjusts thereafter. For example, a
2/1 hybrid ARM has a fixed, usually low, interest rate for the
first two years and adjusts each year thereafter to an amount
equal to a rate index at the date of the adjustment plus a margin.
This margin is often high, resulting in a significant increase
in the new rate charged to the borrower following the adjustment.
their bad credit history, subprime borrowers may have no choice
but to accept these terms; however, they often expect the value
of their properties to rise significantly over the initial teaser
period, which would allow them to refinance or to reestablish
their credit. Some prepayment penalties extend past the two-year
period, complicating the refinancing option. Declining real estate
prices have made refinancing difficult, resulting in subprime
mortgagors being stuck with unmanageable debt service. The Wall
Street Journal reported on October 24, 2007, that when ARMs
“reset,” the rates can more than double.
cuts by the Federal Reserve may provide some relief, but the problem
with foreclosures is still significant. On September 5, 2007,
the Federal Deposit Insurance Corporation (FDIC) urged lenders
to rework these loans. Sheila Bair, chair of the FDIC, stated:
“Reworking these loans will achieve long-term sustainable
obligations to provide stability to borrowers, investors, and
the marketplace” (www.fdic.gov/news/news/speeches/
archives/2007/chairman/spsept0507.html). Some suggestions
offered by the FDIC are as follows:
the terms of the loan or defer payments;
the loan from an ARM to a fixed-rate loan;
the loan amortization period; or
the past-due amount into the principal balance.
Bush restated his opposition to a federal bailout for this lending
crisis, but said administration initiatives will help still-creditworthy
homeowners renegotiate their mortgages and remain in their homes
(Wall Street Journal, December 17, 2007).
It is not
clear how many lending institutions will heed the suggestions
of the FDIC, or whether the Bush administration’s initiatives
will reduce the problem, but on October 24, 2007, the Wall
Street Journal reported that Countrywide expects to restructure
nearly $16 billion in response to the problem. The effect this
will have on foreclosures is yet to be seen. What is clear is
that some 2 million of these ARMs ($229 billion) are due to reset
before the end of 2011, indicating a substantial problem.
Problems with Foreclosures
many reasons for foreclosure, but the related tax issues are the
same. There are two general tax concerns with a foreclosure. First,
the foreclosure is considered a disposition of real estate resulting
in a realized gain or loss. Second, the foreclosure may become
a write-down or write-off of debt resulting in ordinary income
[see Treasury Regulations section 1.1001-2(c) ex. 8; Revenue Ruling
90-16, 1990-1 CB 12, and Kenan v. Comm’r, 114 F.2d
217 (2d Cir., 1940)]. Because
most foreclosures are on personal residences, disposition gains
may be excluded and losses disallowed [IRC section 121(a) and
(b); IRC section 165(c)]. Debt forgiveness is, however, includable
in gross income.
of gain or loss from the deemed disposition is determined by subtracting
the basis of the property from the sales price. The first $500,000
gain ($250,000 for taxpayers filing singly) on the sale of real
estate used as a personal residence for at least two of the last
five years is excluded from income. Conversely, a loss on the
sale of a personal residence is disallowed. Thus, gains are generally
excluded and losses are disallowed, creating no adverse tax consequences.
tax consequences arise when the deemed selling price is less than
the aggregate of the mortgage principal and unpaid interest and
penalties. IRC section 61(a)(3) states that gross income includes
gains from the sale of property. IRC section 61(a)(12) indicates
that a cancellation of debt (COD) is gross income, separate from
gain on the sale of a personal residence. As such, COD is taxable
as ordinary income regardless of the gain or loss on a sale.
is exacerbated by the fact that the deemed selling price may be
the proceeds of the sale by the mortgage company to a third party
subsequent to the foreclosure. Because the selling price from
a distress sale may be low and the unpaid interest large, a significant
tax problem may result.
Assume that a residential home was purchased in 2005 for $200,000.
The value of the home has declined to $180,000 and payments are
in arrears. The delinquency has added interest and late fees to
the mortgage balance, which is now $198,000. The mortgagee (bank)
forecloses on the home and later resells it for $170,000. The
result is a nondeductible loss of $30,000 and COD income of $28,000.
– $200,000 Cost
$ 30,000 Loss
on sale of personal residence (not deductible)
debt and past-due interest
– $170,000 Deemed
$ 28,000 COD
It is clear
that the negative tax consequence is the result of two items:
the low selling price received by the mortgage company, and the
high debt resulting from accrued interest and penalties. The negative
consequence is often magnified if the homeowner has both a first
and a second mortgage. In this situation, the first mortgagee
is concerned only with recouping the investment (the first mortgage
and accrued interest), and may be willing to sell at a below-market
price. This results in a lower selling price, a greater loss to
the second mortgagee, and a greater tax liability for the taxpayer.
interest and penalties accrue until the financial institution
writes off the debt. The debt write-off does not occur until the
property is resold, a personal indemnity suit is settled, and
the taxpayer is found unable to pay. The taxpayer will continue
to experience an increase in ordinary income equal to the additional
interest and penalties until the process is complete, resulting
in a greater tax liability.
several ways that COD income may be mitigated. This includes situations
in which the taxpayer is insolvent or in Title 11 bankruptcy,
the debt is nonrecourse, the taxpayer deeds the title to the mortgagee
in lieu of foreclosure, or when the taxpayer sells the personal
residence and remits the proceeds to the mortgagee. The debt forgiveness
is subject to the Mortgage Forgiveness Debt Relief Act of 2007.
taxpayer is insolvent or in Title 11 bankruptcy.
COD income related to a personal residence is excluded from a
taxpayer’s income under either a Title 11 bankruptcy or
insolvency [IRC section 108(a)(1)(A) and (B)]. Insolvency is defined
as the taxpayer having personal debts that exceed the fair market
value of the taxpayer’s assets, both before and after the
discharge of indebtedness. For example, if before a home foreclosure
a taxpayer’s debts are $300,000 and the value of assets
is $250,000, insolvency is $50,000. If the value of the home is
$200,000 but the total mortgage debt is $220,000, then after the
foreclosure, total debt is $80,000 ($300,000 – $220,000)
and the value of assets is $50,000 ($250,000 – $200,000).
The taxpayer is still insolvent by $30,000 ($80,000 – $50,000),
and no COD income will result.
To the extent
the taxpayer is solvent after debt forgiveness, COD income is
required. For example, if the taxpayer originally had assets valued
at $295,000, $15,000 of COD income is included in gross income
[($295,000 – $200,000 value of home) – ($300,000 –
$220,000) = $15,000] solvency after the foreclosure. Ordinary
income is reported to the extent of this $15,000 solvency.
debt is nonrecourse. For recourse debt, the selling
price is equal to the proceeds to the lending institution upon
their disposition of the property. For nonrecourse debt the selling
price is the total of the mortgage principal and past-due interest
and penalties. [See Treasury Regulations section 1-1001-2(b) and
(C) Ex. 7; Tufts v. Comm’r, 70 T.C. 756, 763–766.]
Because a taxpayer is not personally liable for nonrecourse debt,
the taxpayer’s wealth increases by the amount of debt relief
(including past-due interest and penalties), resulting in an imputed
sales price that often exceeds market value. This treatment increases
the gain on the sale of a residence (or decreases the loss), but
the $500,000 ($250,000 for taxpayers filing singly) exclusion
often eliminates any taxable gain. There is no COD gain, because
the imputed sales price is equal to the nonrecourse debt.
In a recourse
loan situation, the bank may file for personal indemnity, forcing
the taxpayer to pay the remaining debt ($28,000 in the earlier
COD example). The bank is barred from such action on a nonrecourse
taxpayer deeds title to the mortgagee in lieu of foreclosure.
A taxpayer may initiate contact with the mortgage company, reconvey
title to the mortgagee, and vacate the premises. This act saves
the mortgagee the time and cost of the foreclosure process. It
also stops the accrual of unpaid mortgage interest and related
penalties that would otherwise continue to accumulate until foreclosure
is completed. This will reduce the amount of COD income when the
sale price of the home is less than the debt.
taxpayer sells the personal residence and remits proceeds to the
mortgagee. The taxpayer may sell the residence to
a third party at a price below market but in excess of the outstanding
debt, including accrued interest and penalties. No COD income
exists in this situation. The homeowner may sell at a price less
than the outstanding debt, including interest and penalties, but
should consider the tax consequences of foreclosure when determining
the selling price.
Forgiveness Debt Relief Act of 2007
2007, President Bush signed the Mortgage Forgiveness Debt Relief
Act of 2007. It will rescue many families facing foreclosure on
their personal residences (see H.R.3648 and S.1394, Mortgage Forgiveness
Debt Relief Act of 2007). Referring to the House version that
passed on October 4, 2007, House Ways and Means Committee Chair
Charles B. Rangel (D-N.Y.) said:
It is just
not right or fair that families struggling through a foreclosure
would then face a tax bill in addition to losing their homes
when they have seen no increase in their net worth. This bill
rights that wrong and provides tax relief to millions of American
families. [See Tax Analysts 2007 TNT 194-1.]
law excludes from gross income up to $2 million of COD income
by reason of debt reduction of a qualified principal residence
indebtedness for foreclosures between January 1, 2007, and December
31, 2009 [new IRC section 108(a)(1)(E)].
of the law include:
principal residence indebtedness is defined as any indebtedness
incurred in acquiring, constructing, or substantially improving
the principal residence of a taxpayer if the debt is secured
by the residence. In addition, committee reports state that
any indebtedness secured by the principal residence resulting
from refinancing is allowed if the refinanced debt does not
exceed the debt immediately prior to refinancing. For example,
qualified principal residence indebtedness refinanced to obtain
a lower interest rate is allowed.
- The basis
of the individual’s principal residence is reduced by
the amount excluded from income. This will increase the gain
or decrease the loss on the foreclosure sale; however, because
a personal loss is disallowed and the first $500,000 ($250,000
for single filers) gain is excluded, there will likely be no
effect on the taxability of the foreclosure.
- The new
law does not eliminate all COD income for taxpayers. Home equity
loan debt used for any purpose other than to substantially improve
the principal residence is not excluded. Debt relief on mortgage
debt not related to the home, such as educational, medical,
and consumer debt, remains subject to COD income.
- The new
law is effective for discharges of indebtedness between January
1, 2007, and December 31, 2009. The sunset provision was included
because Congress remains committed to the all-inclusive income
concept stated in IRC section 61(a)(12), that cancellation of
debt is income because it increases a taxpayer’s wealth.
Senate Finance Committee Chair Max Baucus (D-Mont.) stated:
From a tax
standpoint, a forgiven loan is income. Hopefully we’re in
a temporary situation here [with the housing crisis], and that’s
why in my judgment the exemption should be temporary. [See 2007
TNT 96-26, S.1394.]
- The COD
exemption applies to a taxpayer’s personal residence as
defined in IRC section 121. Vacation homes or other real estate
investments do not qualify for the exemption.
The COD exemption
does not apply if the loan is discharged in exchange for services
or if the taxpayer is in Title 11 bankruptcy. The exemption does
apply if the taxpayer is insolvent, unless the individual elects
to use the insolvency rules.
losing their personal residences from a foreclosure in 2007, 2008,
or 2009 may use the new tax rules of IRC section 108 to exclude
gain from their COD income. Only mortgage debt forgiveness that
was not used for acquisition, construction, or substantial home
improvements is taxable income. Because many taxpayers at risk
of foreclosure may have used a second mortgage to finance items
unrelated to their residence, the benefits of the new law may
who file a Title 11 bankruptcy, or are insolvent before and after
the foreclosure (and elect to use the insolvency rules rather
than the new COD tax exclusion), do not have to report COD income.
The insolvency rules are preferable over the new rules if the
taxpayer has a consumer debt mortgage, which is not excluded from
income under new IRC section 108. Rules for determining insolvency
are beyond the scope of this article, but should be used if appropriate
(see Treasury Regulations section 1-108-6).
who have experienced foreclosure and are required to include COD
income under the Mortgage Forgiveness Debt Relief Act of 2007
should consider challenging the reasonableness of the selling
price received by the financial institution. For example, a recent
article reported a case in which a taxpayer lost his home through
foreclosure (Geraldine Fabrikant, “After Foreclosure, a
Big Tax Bill from the IRS,” New York Times, August
20, 2007), resulting in back taxes of $34,603. The bank, and only
bidder, bought the home in a foreclosure sale for $1. It reported
COD income (Form 1099C) to the taxpayer for the difference between
the mortgage debt and $1. Because $1 was not representative of
the fair market value of the home, the taxpayer challenged the
1099C. The lending institution eventually changed the reported
COD, eliminating all taxes from the foreclosure.
may refute any COD income reported on a 1099C by both monitoring
the subsequent lender sale of the foreclosed property and the
resale of the property by the third party who bought it from the
lender. This information will support both a corrected Form 1099C
and the taxpayer’s assertion to the IRS that the 1099 is
may also document market value by obtaining an independent appraisal
before the foreclosure occurs. The appraised value or proceeds
from a subsequent sale of the property can be used to support
a new fair market value for COD purposes.
are typically eligible for a mortgage interest deduction upon
losing the personal residence. This occurs when the sales proceeds
are in full or partial satisfaction of the unpaid interest and
penalties. The lending institution may not report an interest
payment on Form 1098 for the taxpayer, as no actual payment was
made. In effect, payment is made to the lender in the form of
the sales proceeds the lender receives for the foreclosed property.
State laws often require that payments are attributed to interest
before principal. In this situation, all unpaid interest is allowed
as a mortgage interest deduction. The taxpayer should claim the
proper amount of the unpaid interest and penalties.
All COD income
must be reported by lending institutions. The burden of proof
for exclusion of COD rests with the taxpayer, who must be able
to substantiate that loan proceeds were used to substantially
improve the principal residence. Prior to the Mortgage Forgiveness
Debt Relief Act of 2007, there was no tax reason to retain documentation;
therefore, taxpayers may find it difficult to support the expenditures.
All taxpayers at risk should retain documentation to support expenditures
related to substantial improvement of the principal residence.
the foreclosure crisis started in 2006, homeowners who reported
COD income on their 2006 returns have almost no chance to argue
that the debt was forgiven in 2007 due to a continuing personal
liability on the mortgage note after the foreclosure sale. Any
COD income reported in 2006 was due to the mortgagee issuing a
Form 1099C, stating the amount and date of the mortgage debt cancellation
are expected in the coming years. Recent efforts by the federal
government are aimed at reducing that number. For the remainder,
the Mortgage Forgiveness Debt Relief Act of 2007 may relieve the
burden of a tax liability resulting from foreclosure. The exclusion
does not extend to taxpayers who obtained second mortgages for
cash unrelated to home improvements, and its documentation requirements
may cause a burden; nonetheless, the exclusion is significant—estimated
to amount to $600 million in tax savings (Tax Analysts,
2007 TNT 244-1).
English, PhD, CPA, is a professor of accountancy and Bill
Lathen is a professor of taxation, both at the college
of business and economics at Boise State University, Boise, Idaho.