Bar News - August 23, 2013
Avoiding the One-Two Punch of Foreclosure and Taxes
By: Robert Hill
Although the housing market is improving, many homeowners owe more on their property than the property is worth and continue to struggle to make required mortgage payments. Clients in this situation will need your guidance, especially if they are considering loan modifications, short sales, or foreclosure, each of which has significant tax consequences.
To the extent a taxpayer is solvent, discharged debt is income for federal tax purposes. With the onset of the housing crisis, many taxpayers began seeking loan modifications or forgiveness on their mortgages. Others sold “short,” walking away from their property in exchange for forgiveness of their mortgage.
In the process, banks and other loan originators wrote off large amounts of mortgage debt. The taxpayers involved in these transactions were hit with a one-two punch; their credit worthiness was damaged and they found themselves facing a large and unexpected tax liability. Congress recognized the inequity of this result and responded with the Mortgage Forgiveness Debt Relief Act of 2007.
This act added Section 108(a)(1)(E) to the Internal Revenue Code. The new section excludes from income the discharge of qualified personal residence indebtedness (QPRI). The exclusion applies to discharges of QPRI occurring between Jan. 1, 2007, and Dec. 31, 2013.
A “principal residence” is a primary dwelling that the taxpayer has owned and used for at least two of the last five years. In the case of a married couple, only one spouse must fulfill the ownership requirement, but both must fulfill the use requirement for the residence to qualify.
QPRI is debt secured by the principal residence and used to acquire, construct, or significantly improve that residence up to a statutory limit of $1 million for single filers and $2 million for married couples filing jointly. A mortgage used to purchase the principal residence is 100 percent QPRI, subject only to the statutory maximums.
A second mortgage secured by the principal residence and used to pay off consumer debt or to pay for school tuition is not QPRI. If the second mortgage pays off the first mortgage, the second mortgage is QPRI, up to the dollar amount of the first mortgage, so long as the first mortgage was QPRI. It’s important to note that the exclusion from income only applies if the discharge occurs because of the decline in the value of the property or a change in the borrower’s financial circumstances.
When QPRI is discharged, the taxpayer must report the discharge, either as income or by claiming the exclusion of Section 108(a)(1)(E) in the tax year that the discharge occurred. To claim the exclusion, a taxpayer files a Form 982 with details about the discharged debt. The taxpayer must also reduce his or her basis (the taxpayer’s value in the property by which the debt was secured) by the dollar amount of the discharged QPRI excluded from income. This reduction in basis will affect the calculation of gain or loss from a future sale or foreclosure.
Whether discharged debt is QPRI subject to exclusion is a matter of fact that involves proving ownership and use, plus accounting for expenditure of the funds.
Suppose that in 2008, Joe Taxpayer purchased a home for $550,000. He put $50,000 down and used a $500,000 loan from Bank X, secured with a mortgage on the property. Several years later, Joe loses his job and can no longer make his minimum monthly payments. Bank X offers Joe a $100,000 reduction on his principal, in recognition of the change in his financial circumstance. Because Joe has lived in the home as his primary residence for more than two years, and the discharged debt was acquisition debt, the debt discharged is QPRI. Joe must file a Form 982 to exclude the $100,000 debt discharge from his income and must reduce his basis in the home by $100,000. His new adjusted basis is $450,000.
It is important to note, however, that even if a client qualifies for exclusion of QPRI discharge income, it may not be in the client’s best interest to accept a loan modification or other forgiveness of debt. Imagine in the first example that Joe refinanced a year after the original loan with a new $600,000 loan.
Joe then uses the first $500,000 to satisfy the original note and the remaining $100,000 for personal expenses. When Joe subsequently loses his job, Bank X offers Joe the same $100,000 in debt forgiveness. The consequence of this offer is different from the first scenario, because when a discharge of debt is part QPRI and part non-QPRI, the non-QPRI portion is discharged first. In Joe’s case, the $100,000 is all non-QPRI and, therefore, he would have to report it as taxable income, if he accepted the debt forgiveness.
When representing clients who are contemplating loan modifications, attorneys should consider the extent to which the debt is not QPRI and the potential tax consequences of the proposed modification.
Robert Hill is a student at UNH Law and an intern for the Low-Income Taxpayer Project at the NH Bar. He is grateful to LITP Coordinator Barbara Stewart and attorneys Beth Fowler and Krista Atwater for their assistance with this article.