The Mortgage Forgiveness Debt Relief Act of 2007

By Lynn Comer Jones, Ph.D., CPA


  • Under the act, a taxpayer may exclude from income $2 million ($1 million if married filing separately) in principal mortgage indebtedness forgiveness on a qualified principal residence during 2007, 2008, and 2009.

  • The mortgage interest deduction for mortgage insurance premiums is extended through December 31, 2010.

  • State and local tax benefits and qualified payments to members of qualified volunteer emergency response organizations are excluded from income through December 31, 2010.

  • $500,000 of capital gain income from surviving spouse qualified home sales can be excluded from income beginning January 1, 2008.

Early in the decade, lenders were willing to loan money to home buyers with bad or no credit (subprime loans). Lenders were hedging losses (i.e., from future foreclosures) on the significant appreciation the housing market was experiencing. In addition, lenders were enticing borrowers with adjustable-rate mortgages (ARMs). ARMs, with interest rate adjustments that are tied to the federal funds rate (FFR) (the rate at which banks make unsecured loans to each other), are an excellent financing tool when the market conditions are right (i.e., the FFR is decreasing). However, in 2003 the annual effective FFR was a mere 1.13%, the lowest of any year in the Federal Reserve’s published historical data (going back to 1955).1 Thus, the market was moving in a direction that was detrimental to ARMs. As the FFR increases, homeowners’ mortgage payments begin to escalate and defaults increase.

These conditions were the catalyst for the subprime mortgage crisis. Subprime mortgage borrowing nearly tripled in 2004 and 2005. However, with the subsequent decline in house prices, higher FFR, and slower economic growth, the delinquency rate among subprime borrowers has risen dramatically. The rise is attributable mostly to borrowers with ARMs.2

In response to the subprime mortgage crisis, the Mortgage Forgiveness Debt Relief Act of 2007, P.L. 110-142 (MRA), was signed into law on December 20, 2007. This act excludes from income the discharge of qualified principal residence indebtedness. Its discharge provisions are temporary and apply to discharges during 2007, 2008, and 2009.

The act also made several other important changes, including:

  • Allowing surviving spouses to qualify for the $500,000 exclusion for capital gain on the sale of a principal residence;
  • Extending the mortgage interest deduction for mortgage insurance premiums;
  • Adding qualification criteria for cooperative housing corporations; and
  • Excluding from income certain state and local tax benefits of volunteer firefighters and emergency responders.

Treatment of Discharge of Indebtedness

Sec. 61(a)(12) requires income recognition for discharge of mortgage indebtedness. However, certain exceptions exist for discharges in the case of bankruptcy (Sec. 108(a)(1)(A)) or insolvent taxpayers (Sec. 108(a)(1)(B)). Bankrupt taxpayers may exclude income as long as the debt discharge is part of a court-approved bankruptcy plan (Sec. 108(d)(2)). Insolvent taxpayers (whose liabilities exceed the fair market value (FMV) of their assets) avoid income recognition as long as the discharge amount does not exceed the borrowers’ insolvency position.3

The tax effect of debt discharge is different for solvent taxpayers, those with personal debt (credit cards and mortgage) that does not exceed their home value plus other assets. Solvent taxpayers recognize ordinary income on canceled recourse debt4 to the extent it exceeds the value of the assets (typically the FMV of the home) given to satisfy the discharge.5 Recourse debt is the typical lending arrangement for mortgages. In the past decade, lenders have allowed some buyers to borrow 95% to 100% of the home’s purchase price. Moreover, the lending arrangements typically consisted of first mortgages at 80% with the remaining 15% or 20% financed via second mortgages (with higher fixed interest rates) or equity lines of credit.

Currently, with home prices decreasing, homes may have FMVs less than the associated mortgages. Foreclosures on high loan-to-value recourse debt make the effects of the historical debt forgiveness provisions even worse. In addition to losing their homes, homeowners might have to recognize ordinary income equal to the excess debt (i.e., debt less the home’s FMV).

Mortgage Relief

Solvent taxpayers benefit from the MRA because they are not eligible for the insolvency exclusion (Sec. 108(a)(1)(B)). The act excludes qualified principal residence mortgage forgiveness from income as long as the discharge occurs on or after January 1, 2007, and before January 1, 2010 (Sec. 108(a)(1)(E)). Taxpayers’ qualified principal residence is one they have owned, and lived in, for two of the five prior years (Sec. 121 and Sec. 108(h)(5)). Thus, second homes and rental property are excluded in the MRA. Qualified principal residence indebtedness includes debt for the acquisition, construction, and/or improvement of the home (i.e., acquisition indebtedness per Sec. 163(h)(3)(B)). A second mortgage or home equity line of credit (HELOC) will qualify as principal residence indebtedness as long as the loan proceeds are used for acquisition/construction or home improvement.

The discharge can be in full (foreclosure) or in part (loan rewrite). The maximum exclusion is $2 million ($1 million for married taxpayers filing separately) (Sec. 108(h)(2)). Instead of including the forgiveness as income, the exclusion reduces the taxpayers’ principal residence basis (Sec. 108(h)(1)).

In the case of a partial discharge, the tax benefit may be lost in part or in full. This occurs if the taxpayers subsequently sell the reduced-basis home, realizing a larger gain. To the extent a gain is realized, it may be excluded to the maximum of $250,000 ($500,000 married filing jointly) (Sec. 121). Thus, in theory, the debt relief benefit provided under the MRA may operate as a tax deferral rather than a permanent exclusion.

Practice tip: The reduction in basis of the home due to the debt discharge is reported on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), which must be attached to the taxpayer’s return for the year the debt discharge is excluded from income.

Example 1: H and W, a married couple, purchased a home in 2003 when the real estate market was appreciating rapidly. They financed 95% ($950,000) of the $1 million purchase price. They depleted nearly all of their savings last year because H had to pay for his mother’s health care when she was diagnosed with a catastrophic illness. However, H and W are solvent because of their retirement savings. W lost her $300,000 per year financial services position this year when the firm downsized. They consider using early retirement distributions to cover their mortgage payments but realize they would be liable for taxes and penalties. If they sell their home, which has a current market value of only $750,000, they will be unable to pay the $891,000 mortgage balance in full.

Option A: If H and W fail to make their mortgage payments, the lender will foreclose. This will result in debt forgiveness of $141,000 ($891,000 debt – $750,000 FMV/foreclosure sale price), which is excluded from H and W’s income. However, they will lose their home.

Option B: Since they have an excellent payment history and have experienced financial hardships, they decide to approach the lender. In lieu of foreclosure proceedings, the lender is willing to rewrite the loan with a principal balance of $750,000. This will reduce their monthly mortgage payments by $1,100. H and W have enough savings to pay the reduced mortgage payment for three months, enough time for W to secure another job. They accept the lender’s offer. The debt forgiveness of $141,000 ($891,000 – $750,000) reduces the basis in their home to $859,000 ($1 million cost – $141,000 forgiveness).

Several years later, H and W decide to sell their home when the real estate market appreciates. They sell their home for $1.5 million. The $641,000 ($1.5 million sales price – $859,000 adjusted basis) capital gain is eligible for Sec. 121 exclusion. Thus, $500,000 is excluded from income and the remaining $141,000 is recognized as capital gain. If H and W did not have debt forgiveness, their home’s basis would be its original cost, and the realized gain of $500,000 ($1.5 million sales price – $1 million cost basis) would be fully excluded. Because of the debt forgiveness H and W have an income deferral, rather than income exclusion, of $141,000.


Some restrictions to the income exclusion apply. Discharges resulting from the performance of services for the lender do not qualify for income exclusion. Similarly, the income exclusion is not available for conditions not related to declines in the property value or the taxpayers’ financial condition (Sec. 108(h)(3)). An ordering rule is imposed such that the discharge is reduced by any amount that is not qualified principal residence indebtedness (Sec. 108(h)(4)).

Example 2: Using the facts from Example 1, assume H and W opened a HELOC in 2004 when the real estate market was appreciating. The total HELOC borrowing was $80,000. They used $60,000 for home improvements and $20,000 to purchase a car. Thus, 75% of the HELOC was used for home improvement and 25% for personal use. At the time of discharge, the HELOC had a $78,000 principal balance. The lender agrees to rewrite the loan at a principal amount of $60,000. The total discharge is $18,000 ($78,000 – $60,000). Only $13,500 (75%) will be eligible for exclusion. The remaining $4,500 (25%) will not be eligible for the qualified principal residence mortgage forgiveness income exclusion under Sec. 108(h). Rather, the $4,500 will be viewed as discharge of indebtedness under the historical rules. H and W will recognize the $4,500 as ordinary income (Sec. 61(a)(12) and Regs. Sec. 1.1001-3(b)).

Finally, the principal residence ex-clusion takes precedence over the insolvency exclusion (Sec. 108(a)(1)(B)) unless taxpayers elect to use the insolvency provision (Sec. 108(a)(2)(C)).

Example 3: If H and W are insolvent and choose to retain their home (under the facts of Example 1, Option B), it will be beneficial for them to make the election for the insolvency provision if the amount of the discharge does not exceed their insolvency (Sec.108(a)(B)). This will ensure that H and W do not have any recognition of deferred gain on the future sale of their home. Specifically, the insolvency debt discharge is an income exclusion (i.e., it does not reduce home basis).

Option A: H and W are insolvent. Their liabilities (mortgage debt plus other debt) exceed their total assets (home’s FMV plus assets) by $160,000 (Sec. 108(d)(3)). Since their insolvency position is greater than the $141,000 debt discharge, H and W do not recognize any discharge of indebtedness income if they make the election to apply the insolvency provision (Sec. 108(a)(1)(B)). Thus, H and W would realize $500,000 ($1.5 million sales price – $1 million cost basis) on the sale of their home. However, none of the realized gain would be recognized (Sec. 121).

Option B: H and W are insolvent. Their liabilities (mortgage debt plus other debt) exceed their total assets (home’s FMV plus assets) by $120,000. Since their insolvency position is less than the $141,000 debt discharge, H and W recognize $21,000 ($141,000 debt discharge – $120,000 insolvency position) discharge of indebtedness income. Thus, H and W should not make the insolvency election under Sec. 108(a)(2)(C) to avoid immediate income recognition. Specifically, it would be preferable for them to use the qualified principal residence forgiveness exclusion when they sell their home (Sec. 108(h)).

Other Provisions of the MRA

Mortgage Insurance Premiums

Borrowers are required to purchase private mortgage insurance if their down payment is less than 20% of the home’s sale price. The insurance protects the lender in the event of default. Under Sec. 163(h)(3)(E), premiums a taxpayer pays for qualified mortgage insurance on a mortgage secured by his or her principal residence are deductible as qualified residence interest. The deduction is reduced by a 10% phaseout per $1,000 of income ($500 married filing separately) in excess of $100,000 ($50,000 married filing separately) (Sec. 163(h)(3)(E)(ii)).

The deduction was scheduled to expire at the end of 2007, but the MRA extends to December 31, 2010, the treatment of mortgage insurance premiums as deductible mortgage interest (Sec. 163(h)(3)(E)(iv)(I)). This applies to amounts paid or accrued after December 31, 2007, but does not apply to mortgage insurance contracts issued before January 1, 2007.

Cooperative Housing Corporations

The MRA adds qualification tests that should make it easier to qualify as a cooperative housing corporation. Cooperative housing corporation tenant-stockholders are allowed deductions for taxes, interest, and business depreciation. Sec. 216(b)(1)(D) is amended to include two additional qualification tests. Prior law required that 80% or more of the corporation’s gross income come from tenant-stockholders.

The new law alternatively allows a cooperative to qualify by meeting a square footage or an expenditures test. Under the square footage test, 80% or more of the total square footage of the corporation’s property must be used, or be available for use, by tenant-stockholders for (ancillary) residential purposes. Under the expenditures test, 90% or more of the corporation’s expenditures must be for the acquisition, construction, management, or maintenance of the corporation’s property. As long as one or more of the tests is met, the corporation qualifies. The amendment is effective for tax years ending after December 20, 2007.

Volunteer Firefighters and Emergency Medical Responders

The MRA adds a new Code section, Sec. 139B. This section provides two benefits to members of qualified volunteer emergency response organizations (volunteer firefighters and emergency medical responders) (Sec. 139B(c)(3)). First, members can exclude qualified state and local tax benefits (reduction or rebate of tax) from gross income (Sec. 139B(a)(1)). These include benefits for state and local real property, personal property, and income taxes (Sec. 139B(c)(1) and Secs. 164(a)(1), (2), and (3)). Double benefits (i.e., a Sec. 139B income exclusion and a state and local tax itemized deduction) are prohibited (Sec. 139B(b)(1)).

Second, qualified payment (including reimbursement) for services as an emergency volunteer is excluded from gross income (Sec. 139B(a)(2)). For example, mileage reimbursement could be excluded. However, double benefits of the exclusion and a charitable (mileage) itemized deduction are prohibited (Sec. 139B(c)(2) and Sec. 170(i)).

The qualified payment exclusion maximum is $30 per month of service (maximum $360 annually) (Sec. 139B(c)(2)). The new Code section applies to tax years beginning after December 31, 2007, and before January 1, 2011 (Sec. 139B(d)).

Student Housing

For purposes of the low-income housing credit, low-income housing units are not disqualified if they are occupied entirely by certain full-time student tenants. The MRA amends Sec. 42(i)(3)(D)(ii)(I) to clarify that the exception for full-time students applies when the students are single parents if neither the students nor their children can be claimed as dependents by another taxpayer; however, the children can be claimed by the student-parent. The amendment is effective immediately and applies to housing credits allocated before, on, or after December 20, 2007.

Capital Gain Exclusion on Home Sales

The MRA allows an unmarried individual whose spouse is deceased (surviving spouse) to exclude $500,000 of capital gain as long as he or she sells the home within two years of the spouse’s death (Sec. 121(b)(4)). The decedent and the surviving spouse must have owned and lived in the house two of the five years prior to the decedent’s death (Sec. 121(a); Sec. 121(b)(2)(A)(i) and (ii)). The exclusion amount applies to sales or exchanges after December 31, 2007.

Revenue Raisers

The cost of the MRA should be fully offset with various revenue-raising provisions. The Joint Committee on Taxation has estimated that the new law will increase revenue by $123 million from 2008 to 2017.6

Partnership Returns

The new law increases the penalty for failure to file partnership returns from $50 to $85 per month (Sec. 6698(b)(1)) and extends the penalty period from 5 to 12 months (Sec. 6698(a)). The maximum penalty is $1,020 (12 months × $85) times the number of partners. This provision is effective for returns filed after December 20, 2007.

Caution: Legislation enacted the day before the MRA, the Virginia Tech Victim’s Relief Act, P.L. 110-141, increased the dollar amount under Sec. 6698(b)(1) by $1 for returns filed for tax years beginning in 2008. Thus, the per-partner penalty for filing a late or incomplete partnership return will be $86 per partner (for a maximum of 12 months) for tax years beginning in 2008.

S Corporation Returns

The MRA also imposes a penalty (in addition to the penalty under Sec. 7203) for the failure to timely file (including extensions) an S corporation return (Sec. 6699(a)(1)). A penalty of $85 per month times the number of S corporation shareholders is assessed (Secs. 6699(a)(2) and 6699(b)(1), (2)). The maximum penalty is $102,000 (12 months × $85 × 100 maximum shareholders)7 and is assessed against the S corporation (Sec. 6699(c)). The provision is effective for returns filed after December 20, 2007.

Corporate Estimated Taxes

The act increases the third-quarter 2012 corporate estimated tax payment. This tax applies to corporations with assets of at least $1 billion. The factor (in Section 401(1)(B) of the Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222, as amended) is increased by 1.5 percentage points.

Joint Committee on Taxation Projections

The Joint Committee on Taxation (JCT) projects the following revenue losses (in millions) for the relief act provisions for the period 2008–17:

  • Discharge of principal residence indebtedness ($606);
  • Extension of interest deduction for private mortgage insurance ($191);
  • Modification of cooperative housing corporation qualifications ($22);
  • Volunteer firefighter and emergency medical services income exclusions ($267);
  • Reprieve for full-time student tenants for purposes of housing cooperatives qualifying for the low-income housing tax credit (less than $5); and
  • Surviving spouse’s home sale gain exclusion ($67).

The JCT projects the following revenue offsets (in millions) for the relief act provisions for the period 2008–17:

  • Partnership returns’ failure to file penalty increase ($458);
  • S corporations’ failure to file penalty ($818); and
  • Corporate estimated tax factor increase ($0; an increase of $912 in 2012 and a decrease of $912 in 2013).

In total, the JCT has estimated that the new law will increase revenue by $123 million from 2008 to 2017.8


The major tax benefit the MRA provides is income exclusion for forgiveness of principal mortgage indebtedness. The maximum exclusion is $2 million ($1 million for married taxpayers filing separately) and reduces the home’s basis. This is beneficial to solvent taxpayers affected by the subprime mortgage crisis. The magnitude of the benefit is contingent upon whether the home is foreclosed or whether the loan is rewritten. In addition, the exclusion may result in tax deferral, rather than a permanent exclusion, if the taxpayer retains and subsequently sells the reduced-basis home.

For more information about this article, contact Prof. Jones at


1 See The 2007 annual effective FFR was 5.02%.

2 Bernanke, “The Housing Market and Subprime Lending,” speech to the 2007 International Monetary Conference, Cape Town, June 5, 2007.

3 Sec. 108(a)(1)(B). See Wood, “Subprime Lending Controversy Fuels Familiar Tax Issues,” 38 The Tax Adviser (December 2007): 714–16.

4 Regs. Sec. 1.1001-2 (Example 2) and Sec. 7701(g) exempt nonrecourse loans from the forgiveness of debt rules.

5 See Picha and Hiraldo, “Short Sale or Foreclosure of a Principal Residence,” 38 The Tax Adviser (September 2007): 507–9; and “Forced Home Sale Can Result in Income to the Borrower,” 204 Journal of Accountancy (September 2007): 88.

6 Joint Committee on Taxation, Estimated Revenue Effects of H.R. 3648, “The Mortgage Forgiveness Debt Relief Act of 2007” as Amended and Passed by the Senate on December 14, 2007 (JCX-118-07), December 18, 2007,

7 Sec. 1361.

8 Joint Committee on Taxation, Estimated Revenue Effects of H.R. 3648 (JCX-118-07).


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