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IRS guidelines spell out tax relief for homeowners getting mortgage reductions

IRS allows 'underwater' homeowners tax relief

WASHINGTON — With the Obama administration and private lenders considering mortgage principal-reduction programs for financially distressed homeowners, the Internal Revenue Service has issued a new advisory to taxpayers who would receive or seek such assistance.

The IRS gets involved in these situations because the federal tax code generally treats any forgiveness of debt by a creditor in excess of $600 as ordinary taxable income to the recipient.

However, under legislation that took effect in 2007, certain home mortgage debt cancellations — such as through loan modifications, short sales or foreclosures — may be exempted from tax treatment as income.

Sheila C. Bair, chairwoman of the Federal Deposit Insurance Corp., recently confirmed that her agency is working on a new program to expand the use of principal mortgage reductions to keep underwater borrowers out of foreclosure. Major banks and mortgage companies have preferred monthly payment reductions and other loan modification techniques over cuts of principal balances, but a handful have made limited use of the concept.

One of the largest servicers of subprime home loans, Ocwen Financial Corp. of West Palm Beach, has strongly advocated principal reductions to keep people out of foreclosure and claimed broad success with them. Ron Faris, president of Ocwen, testified to a congressional subcommittee earlier this month that borrowers with negative equity are as much as twice as likely to default again after a standard, payment-reduction loan modification as those who receive partial forgiveness on their principal debt.

But what are the tax implications when a lender essentially says "we're going to write off some of what you owe in order to keep you in the house"? IRS guidance issued March 4 spelled out how underwater borrowers can qualify for tax relief when a lender agrees to lower their debt.

To begin with, be aware that the federal tax exclusion only applies to mortgage balances on your principal residence. The maximum amount of forgiven debt eligible under the law is $2 million for married taxpayers filing jointly and $1 million for single filers.

But there are some potential snares: Your debt reduction can only be for loan amounts that you used to "buy, build or substantially improve your principal residence." This includes refinancings that increased your total mortgage debt attributable to renovations and capital improvements of your house. Mortgage debt created for other personal purposes, such as to pay off credit card bills, buy cars or invest in stocks, is not eligible for tax exclusion. In all refinancings, make sure you can document where the money flowed.

When your lender formally forgives all or part of your mortgage balance, the lender is required by law to issue you an IRS Form 1099-C, a "Cancellation of Debt" notice, a copy of which is also sent to the IRS. The form shows the amount of debt discharged and the estimated fair market value of the house.

A few other noteworthy features of the IRS rules: If you've been foreclosed upon or you do a short sale and lose money in the process, don't claim a tax loss on your federal filing. The IRS will turn you down. However, if you go to foreclosure and your lender agrees to cancel all or part of the unpaid mortgage balance as part of the deal, then you can file for an exemption from the IRS.

What if your lender reduces the debt on your house but you continue to own the property and live in it? There's a tax wrinkle in the fine print: The IRS will require you to reduce your "basis" in the house — your "cost" for tax purposes — by the amount of the forgiven debt. But that's not likely a big concern for most homeowners digging their way out of the bust.

Finally, if you want to claim the debt forgiveness exemption, download IRS Form 982 (available at irs.gov) and attach it to your return for the year in which the debt was forgiven. And don't assume this tax code benefit to homeowners will be around forever. It expires at the end of 2012.

Ken Harney can be reached at kenharney@earthlink.net.

IRS guidelines spell out tax relief for homeowners getting mortgage reductions 03/12/10 [Last modified: Friday, March 12, 2010 3:30am]

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