Friday, September 28, 2007

TO ERR IS HUMAN - TO FORGIVE IS TAXABLE

I have been reviewing the various tax blog discussions on the subject of home foreclosures and resulting debt forgiveness.

Tax law professor Jim Maule of MAULED AGAIN provides an excellent description of the situation in his well-named post “Greed, Stupidity. Poor Judgment and Taxes”:

“The recent downturn in the housing market, a predictable and predicted outcome of the rampant speculation in housing fueled by speculators and gamblers bored with the stock market and looking for something more exciting, more profitable, or more instantaneous, has created serious financial problems for homeowners who overreached when purchasing or investing in residential real estate. Those problems include not only loss of the home through foreclosure but higher federal and state income tax liabilities because the foreclosure can generate cancellation of indebtedness income.”

In simpler terms - families who wanted to buy a home that they could not afford found lenders willing to give them a mortgage with a minimal down payment, a low interest rate, and small monthly payments for an initial limited period. When this initial limited period passed and it was time to refinance the mortgage housing prices had dropped – so that the principal balance on the loan was more than the market value of the home – and interest rates had gone up. The overextended families could not afford the new monthly payments and the lenders had to foreclose on the properties.

In many situations the borrowers and lenders reached agreements so that portions of the mortgage debt were “forgiven” by the lenders. This debt forgiveness can result in taxable income to the borrower.
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According to the IRS website’s page of Questions and Answers on Home Foreclosure and Debt Cancellation
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“If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances….The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.
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Here’s a very simplified example. You borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you {and writes off the loan - rdf}, there is a cancellation of debt of $8,000, which generally is taxable income to you.”
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Congress needs some good press so they have proposed “bailing out” homeowners who are now faced with taxable debt cancellation income from these mortgage foreclosures.
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The Mortgage Forgiveness Debt Relief Bill of 2007 (HR 3648) has cleared the House Ways and Means Committee by a unanimous voice vote (see yesterday’s “As the Congress Turns” posting). The bill would permanently exclude from tax liability any mortgage debt on a principal residence that is forgiven following a foreclosure or renegotiation with lenders – providing homeowners affected by the nationwide sub-prime mortgage crisis with $2 billion in tax relief.

Of course, in another testimony to its laziness, Congress has opted for a quick fix that will no doubt win its members votes back home rather than seriously addressing the issue and attempting to find a permanent, meaningful solution to prevent this situation from being repeated in the future.

Jim Maule has wisely pointed out that “The bottom line is that the proposed tax relief doesn’t prevent the foreclosure, doesn’t put the people back into their homes, and doesn’t do much to help them straighten out the mess that their lives have or will become because of the misguided decision to bite off more financial responsibilities than their means would permit them to chew.”

Joe Kristan of ROTH AND COMPANY TAX UPDATES points out in “Sub-Prime Mortgages, Sad Stories and the IRS” that such a bill “would create a new privileged class of income, followed inevitably by unintended consequences. Big companies would probably set up mortgage subsidiaries to make home loans to their executives, which would then be forgiven tax free.” He goes on to correctly observe that “Making mortgage debt tax free would also encourage people to borrow too much for home debt -- something the tax laws do too much already”.

Why do homeowners who have bitten off more than they can chew deserve tax relief any more than individuals who went overboard with credit card debt? Neither of them deserve any special treatment. No one put a gun to their heads to force them to borrow more than they could afford to pay back.

Actually a case could be made that tax relief for those with income from the cancellation of credit card debt is more appropriate. In a majority of cases a substantial portion of the credit card debt cancelled represents a usurious accumulation of excessive finance charges and late, overlimit and other fees.

Any portion of a cancelled debt, including interest, which would have been deductible if paid is not subject to federal income tax. As mortgage interest is generally deductible, any portion of cancelled mortgage debt that represents accumulated deductible interest is not taxable.

Relief already exists for most of the lower-income victims of this mucking fess. Debt cancellation on foreclosure is not taxable to the extent that you are insolvent. That is, to the extent that your liabilities (the money you owe) exceeds the value of your assets (the value of what you own). For tax purposes you are considered insolvent if after reducing your total original liabilities by the amount of debt cancelled your total outstanding debts still exceed the value of your assets.
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You claim this relief on IRS Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness). All you have to do is check the box at Line 1(b) in Part I and indicate the amount of debt forgiveness that is exempt from federal income tax on Line 2. You attach the Form 982 to your Form 1040 for the year in which the debt has been cancelled.
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The Mortgage Forgiveness Debt Relief Bill of 2007 makes tax relief for mortgage debt forgiveness permanent. If this bill is to address the specific current situation why is it not temporary – for debt forgiven in 2007 and 2008 for example?
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The bill also extends the deduction for Private Mortgage Insurance (PMI) for taxpayers making less than $55,000, or $110,000 if filing a joint return, through 2014. I still can’t for the life of me understand the logic (not that tax law has to be logical) of this deduction. The PMI lobby must have spread around a lot of money.
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To pay for the tax forgiveness on debt forgiveness and the extended PMI deduction, the Section 121 exclusion of the gain on the sale of rental or vacation property converted to a personal residence would be reduced beginning in 2008.
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I do not support HR 3648. Congress should not send a message to America that it is ok to be fiscally foolish and live beyond your means because you won’t have to pay the consequences. Those who lost out in this situation made their bed, now they should be made to sleep in it.
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So what do you think?
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TTFN

3 comments:

Anonymous said...

I have read about this silly law several different places but can't seem to get a full understanding of the changes to the principle residence exclusion. I bought a home in June 2005. I rented it our for 1 year and moved in June of 2006. If this law passes and I sell the home in July 2008 (after living in it for 2 years) are my gains tax free?

Robert D Flach said...

Anonymous:

To answer your question let me quote from Joe Kristan (of ROTH AND COMPANY TAX UPDATE BLOG) in his 9/26/07 posting on this aspect of H.R. 3648:

“The cutback on the exclusion would only be for "nonqualified" use after 2007, so you still have three months or so to move into your vacation home, live there for two years, and qualify for the full exclusion. Assuming, of course, the bill will pass.”

So it appears you would not be affected by this bill, as your “nonqualified” use began in 2005.

Joe’s post gives an example of how the reduction would work, taken from the Joint Committee on Taxation’s explanation of the bill:

“Assume that an individual buys a property on January 1, 2008, for $400,000, and uses it as rental property for two years claiming $20,000 of depreciation deductions. On January 1, 2010, the taxpayer converts the property to his principal residence. On January 1, 2012, the taxpayer moves out, and the taxpayer sells the property for $700,000 on January 1, 2013. As under present law, $20,000 gain attributable to the depreciation deductions is included in income. Of the remaining $300,000 gain, 40% of the gain (2 years divided by 5 years), or $120,000, is allocated to nonqualified use and is not eligible for the exclusion. Since the remaining gain of $180,000 is less than the maximum gain of $250,000 that may be excluded, gain of $180,000 is excluded from gross income.”

TWTP

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