Exclusion for Income from Discharge of Indebtedness: Mortgage Debt Forgiveness

By Charles J. Russo, Ph.D., CPA, CMA, Towson University, Towson, MD, Jeffrey W. Mitchell Jr., CPA, MT, Parente Randolph, LLC, Wilmington, DE, and Seth Hammer, Ph.D., CPA, Towson University, Towson, MD

Editor: Anthony S. Bakale, CPA, M. Tax.

The Mortgage Forgiveness Debt Relief Act of 2007, P.L. 110-142, provides an exclusion from income for the discharge of indebtedness (DOI) on a qualified principal residence. The exclusion is effective for home mortgage debt discharged between January 1, 2007, and December 31, 2012 (Sec. 108(a)(1)(E)). (The Emergency Economic Stabilization Act of 2008, P.L. 110-343, extended the exclusion from December 31, 2009, to December 31, 2012.) The amount excluded under this exception is used to reduce the taxpayer’s basis in the residence, but not below zero (Sec. 108(h)(1)).

Income from DOI in General

In general, income from debt forgiveness is excluded under Sec. 108 if the discharge occurs as part of a title 11 bankruptcy, when the taxpayer is insolvent, or when the debt is from “qualified farm indebtedness” (Sec. 108(a)(1)). Prior to 2007, forgiveness of home mortgage debt outside bankruptcy or insolvency resulted in income recognition.

Example 1: T, a taxpayer who is not in bankruptcy or insolvent, owns a principal residence with a $400,000 mortgage, which is foreclosed. The home is then sold for $300,000 in satisfaction of the debt. This results in $100,000 of DOI income includible in T ’s gross income. Likewise, if T and the lender restructure the loan in a workout by reducing the principal to $300,000, T has $100,000 of DOI income includible in gross income.

Due to the mortgage meltdown, Congress alleviated the harshness of this income recognition by adding the exclusion for income from DOI for home mortgage debt discharged from January 1, 2007, to December 31, 2012 (Sec. 108(a)(1) (E)). In general, when income from DOI is excluded under Sec. 108, various tax attributes including basis in properties, net operating losses (NOLs), passive activity losses (PALs), and credit carryovers must be reduced. Therefore, for some taxpayers, application of Sec. 108 results in a deferral rather than an exclusion of income. Other taxpayers, however, who do not have sufficient attributes (NOLs, PALs, etc.) to absorb the full amount of cancellation of debt (COD) excluded may potentially achieve a permanent exclusion of income.

Exclusion for Discharge of Home Mortgage Indebtedness

DOI income includes discharge of an individual’s home mortgage indebtedness. However, DOI income of a qualified principal residence is excluded from gross income for debt discharges from January 1, 2007, to December 31, 2012 (Sec. 108(a)(1)(E)). The exclusion applies whether the taxpayer restructures the debt on the principal residence or the debt is reduced because of foreclosure and sale (IR-2008-17). The exclusion is claimed on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

The exclusion applies only to qualified principal residence indebtedness, which is the same as acquisition indebtedness as defined for purposes of the home mortgage interest deduction. Acquisition indebtedness generally includes debt for acquiring, constructing, or substantially improving a principal residence. While the maximum amount of debt that can be used in calculating the home mortgage interest deduction under Sec. 163 is $1 million ($500,000 for married taxpayers filing separately), the maximum amount of qualified principal residence debt for this exclusion is $2 million ($1 million for married taxpayers filing separately) (Sec. 108(h)(2)). Debt used to refinance qualifying debt is eligible for the exclusion only up to the amount of the original mortgage principal immediately before the refinancing.

Basis Adjustment

The taxpayer must reduce basis in the principal residence by the amount excluded under Sec. 108(h), but not below zero. The reduction of basis will produce a higher gain when the taxpayer later sells the property. However, up to $500,000 of gain on the sale of a principal residence ($250,000 for married taxpayers filing separately) may be excluded under the Sec. 121 home sale exclusion.

Ordering Rule Where Only Part of the Debt Is Qualified Principal Residence Debt

If only part of the home mortgage debt is qualified principal residence debt, the nonqualified debt is treated as being forgiven first (Sec. 108(h)(4)). For example, assume a taxpayer has a $200,000 loan, of which $150,000 is qualified principal residence debt and $50,000 is nonqualified personal debt. If the bank discharges $160,000 of the loan, the first $50,000 is not eligible for the home mortgage exclusion. Only the remaining $110,000 of discharged debt will qualify for the exclusion.

Coordination with the Insolvency and Bankruptcy Exceptions

If a taxpayer is insolvent but not in bankruptcy, the home mortgage exclusion applies unless the taxpayer elects to use the insolvency exception (Sec. 108(a) (2)(C)). If the taxpayer is in title 11 bankruptcy, the bankruptcy exception applies and not the home mortgage exclusion (Sec. 108(a)(2)(A)). Although most taxpayers in foreclosure are insolvent, not all are; some may have retirement accounts or other assets so that total assets exceed liabilities.

Reporting Requirements: Forms 1099-C, 1099-A, and 982

Most taxpayers whose mortgage debt is reduced will receive Form 1099-C, Cancellation of Debt, from the lender. The lender is required to provide this form by February 28 of the year following the debt forgiveness (Sec. 6050P(a); Regs. Sec. 1.6050P-1(a)(4)(i)). The requirement does not apply to debt discharges that are less than $600 (Sec. 6050P(b); Regs. Sec. 1.6050P-1(a)(1)). Form 1099-C must include the amount of debt forgiven (box 2) and the fair market value (FMV) of any property given up in a foreclosure (box 7). The IRS urges taxpayers to check their Form 1099-C carefully and notify the lender immediately if the information is not correct (IR-2008-17).

Taxpayers use Form 982 to exclude all or part of the income from home mortgage debt discharged. A taxpayer must attach the completed Form 982 to his or her Form 1040, U.S. Individual Income Tax Return. Taxpayers whose basis in property is subject to adjustment following DOI are required to abide by the ordering rules contained in Regs. Sec. 1.1017-1.

Some taxpayers, instead of receiving a Form 1099-C, may receive a Form 1099-A, Acquisition or Abandonment of Secured Property. Unlike Form 1099-C, which reports the actual cancellation of debt, Form 1099-A shows the outstanding mortgage principal and the surrendered property’s FMV. Gain is calculated by subtracting the lower of the taxpayer’s basis or the property’s FMV from the loan balance.

Taxpayers who potentially face COD in excess of the allowable gain exclusion ($250,000 for individuals and $500,000 for married couples filing jointly) and are concerned that their reporting form understates the value of their foreclosed home may find it beneficial to investigate whether there has been a subsequent resale of the property. If, for example, a bank sold the property to an investor who obtained a discount resulting from volume purchases, the selling price may not necessarily reflect its true FMV. The subsequent sale of the property to a noninvestor may provide evidence of a more realistic market price. Taxpayers may also want to consider obtaining an independent appraisal prior to a foreclosure.

Reduction of Interest Rates as Debt Forgiveness

Mortgage refinancing at a lower rate obtained in the open market is a nontax issue, as is a rate reduction that is part of the original debt instrument such as the lowering of the interest rate on an adjustable rate mortgage. However, where a lender reduces the interest rate outside the terms of the original debt instrument, the taxpayer may have DOI income if the taxpayer is solvent. Since the subprime mortgage meltdown, these types of debt workouts are taking place at an unprecedented rate. The IRS views certain debt modifications as “exchanges” that may produce DOI income to the borrower. According to Regs. Sec. 1.1001-3, an exchange is deemed to occur only if a modification to a debt instrument is significant. One must first determine whether there is a modification to the debt instrument and then determine if the modification is significant.

Modifications

Regs. Sec. 1.1001-3(c)(1)(i) defines a modification as any alteration, in whole or in part, of a legal right or obligation of the issuer or holder of a debt instrument, including any deletion or addition (Regs. Sec. 1.1001-3(c)(1)(i)). An interest rate reduction that is part of the original debt instrument, as with adjustable rate mortgages, is not treated as a modification (Regs. Sec. 1.1001-3(c)(1)(ii)). However, a reduction in the interest rate outside the original debt instrument is a modification.

Significant Modifications

Under the general rule, a modification is significant if, based on all the facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant (Regs. Sec. 1.1001-3(e)(1)). Under Regs. Sec. 1.1001-3(e), there are four specific categories that are considered to be significant modifications to a debt instrument:

  • Changes in yield;
  • Changes in the timing of payments;
  • Changes in obligor or security; and
  • Changes in the nature of the debt instrument.
If the modification does not fit into any of the four specific categories, the general rule is applied (Regs. Sec. 1.1001-3(f) (1)). Interest rate reductions fall under the specific category of changes in yield and are thus a significant modification resulting in a deemed exchange of a debt instrument. The deemed exchange may result in DOI income. A change in yield of a debt instrument is a significant modification if the yield differs from the original annual yield by more than the greater of one-quarter of 1% or 5% of the annual yield of the unmodified debt instrument. Note that where there is an interest rate reduction outside the original debt instrument, DOI income will not result as long as the new interest rate is at least equal to or greater than the applicable federal rate.

Calculating Whether Reduction in Principal Is a Significant Modification

The following example, taken from Regs. Sec. 1.1001-3(g), Example (3), illustrates the calculation of whether a reduction in principal is a significant modification.

Example 2: A debt instrument issued at par has an original maturity of 10 years and provides for the payment of $100,000 at maturity, with interest payments at the rate of 10% payable at the end of each year. At the end of the fifth year, and after the annual payment of interest, the issuer and the holder agree to reduce the amount payable at maturity to $80,000. The annual interest rate remains at 10% but is payable on the reduced principal.
In applying the change in yield rule, the yield of the instrument after the modification (measured from the date the parties agree to the modification to its final maturity date) is computed using the adjusted issue price of $100,000. With four annual payments of $8,000 and a payment of $88,000 at maturity, the yield on the instrument after the modification for purposes of determining if there has been a significant modification is 4.332%. Thus, the reduction in principal is a significant modification.

Interest Rate Modification Mechanics

Where a significant modification triggers the deemed exchange rules, the borrower is treated as having satisfied the old debt with the issue price of the new debt (Sec. 108(e)(10)). The issue price for the new debt is equal to its stated principal amount unless the new debt failed to provide for adequate stated interest (Sec. 1274; Regs. Sec. 1.1274-2). The new issue price is determined by calculating the present value of all payments under the new debt at the applicable federal rate back to the date of the modification. The DOI is the difference between the principal amount of the old debt and the calculated issue price of the new debt. If the new debt does not have an adequate stated interest rate, the likely result is DOI income.

Interest Rate Debt Modification

The following example shows the effects of interest rate debt modification.

Example 3: B, a borrower, has a mortgage of $80,000 with an interest rate of 12%. The mortgage has 10 years remaining of interest-only payments and a balloon payment of the entire principal at maturity. The bank cut the interest rate to 6% in a debt workout when the applicable federal rate was 7.5% compounded annually. The issue price is determined by discounting all the payments back to the present using the 7.5% applicable federal rate. The present value of the 10 interest payments is $32,948. The present value of the balloon principal payment at the end of year 10 is $38,816. The total present value is $71,764, which is less than the $80,000 remaining principal balance of the original debt. B’s DOI income is $8,236 ($80,000 – $71,764).

DOI income can be avoided if the debt is restructured with a higher stated interest rate so that the present value is equal to the old principal amount. Otherwise, the DOI income may qualify for the Sec. 108 exclusions for bankruptcy or insolvency or for the mortgage debt exclusion.

Change in Timing and/or Amounts of Payments

Where there is a change in the timing or amount of payments, a material modification may occur depending on all the facts and circumstances, including the length of the deferral, the amounts of the payments deferred, and the amount of time from the modification until the payment deferral begins. The deferral may be due to a deferral of payments or an extension of the maturity date (Regs. Sec. 1.1001-3(e)(3)(i)). There is a safe-harbor rule permitting deferral for the lesser of five years or 50% of the original term of the debt instrument (Regs. Sec. 1.1001- 3(e)(3)(ii)). Temporary forbearance is not a modification and is illustrated in the regulations (see Regs. Secs. 1.1001-3(c)(4) and (d), Example (13)).

Planning: Short Sale vs. Foreclosure

If a taxpayer’s potential COD income from a foreclosure is within the allowable federal exclusion limits (i.e., $500,000 joint and $250,000 single) and is not subject to state taxation, foreclosure may be the preferred choice for DOI. Alternatively, if the taxpayer has significant nonqualifying debt that is potentially subject to cancellation, use of a short sale may be advantageous. A short sale normally involves the sale of the property at or near market price with the lender forgiving debt in excess of the sales price.

Example 4: Taxpayer Q has $450,000 in qualifying debt and $100,000 in nonqualifying debt. The selling price in a short sale would be expected to be $500,000 and in a foreclosure $400,000. If the property is sold through a short sale, $50,000 in debt would be canceled, resulting in $50,000 fully taxable DOI income. If the property is sold through a foreclosure, $150,000 in debt would be canceled but $100,000 would be fully taxable.
Assuming that debt is to be forgiven in both cases, the biggest drawback to the short sale may be that it can be a timeconsuming process with an uncertain outcome. (See Hoak, “Short Sales, Slow Sales,” MarketWatch.com (March 27, 2009)).

Conclusion

Reduction of mortgage principal can result in DOI income from reductions in principal or interest rates, changes in the amount or timing of payments, and foreclosure where the property is sold and the mortgage is satisfied for less than the outstanding principal amount of the loan. The mortgage debt exclusion under Sec. 108(h) will alleviate much of the tax burden on financially strapped homeowners who are not in title 11 bankruptcy. Taxpayers should carefully review Forms 1099-C received from lenders and must attach the completed Form 982 to their Form 1040 to claim the mortgage debt exclusion.


EditorNotes

Anthony Bakale is with Cohen & Company, Ltd., Baker Tilly International, Cleveland, OH.

Unless otherwise noted, contributors are members of or associated with Baker Tilly International.

For additional information about these items, contact Mr. Bakale at (216) 579-1040 or tbakale@cohencpa.com.

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