Foreclosure of principal residence and DOI income

Certain taxpayers who have financial difficulties due to the current downturn in the economy may be eligible to request forbearance from foreclosure on their residence (Section 4022 of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136). To be eligible, the mortgage must be a federally backed mortgage loan:

• Insured by the Federal Housing Administration under Title II of the National Housing Act;
• Insured under Section 255 of the National Housing Act;
• Guaranteed under Section 184 or 184A of the Housing and Community Development Act of 1992;
• Guaranteed or insured by the Department of Veterans Affairs;
• Guaranteed, insured, or made by the Department of Agriculture; or
• Purchased or securitized by the Federal Home Loan Mortgage Corporation or the Federal National Mortgage Association.

Borrowers must be experiencing a financial hardship due, directly or indirectly, to the COVID-19 emergency. Borrowers must submit a request to their servicer and affirm that they are adversely affected by the COVID-19 emergency. The forbearance shall last for 180 days and may be extended an additional 180 days, although the borrower may request a shortened period. During forbearance, no additional fees, penalties, or interest may be charged beyond the interest that would have been charged if the borrower made all payments in a timely manner. In addition, unless the property was vacant or abandoned, the mortgage servicer could not instigate foreclosure proceedings from March 18, 2020, through May 17, 2020.

Taxpayers can exclude from gross income a discharge (in whole or in part) of qualified principal residence indebtedness before Jan. 1, 2021 (Sec. 108(a)(1)(E)(i)). The exclusion will also apply to certain discharges in 2021 if the indebtedness is discharged subject to an arrangement that is entered into and evidenced in writing prior to Jan. 1, 2021 (Sec. 108(a)(1)(E)(ii)). Indebtedness is subject to an arrangement that is entered into and evidenced in writing prior to Jan 1, 2021, if (1) before that date, the mortgage servicer sends the borrower-homeowner a notice outlining terms and conditions of modifications; (2) the borrower-homeowner satisfies the conditions; and (3) the borrower-homeowner and servicer enter into a permanent modification of the mortgage loan on or after Jan. 1, 2021 (Notice 2016-72).

The exclusion applies where taxpayers restructure their acquisition debt on a principal residence, lose their principal residence in a foreclosure, or sell a principal residence in a short sale (where the sales proceeds are insufficient to pay off the mortgage and the lender cancels the balance). But the exclusion does not apply if the discharge is on account of services performed for the lender (for example, if the borrower is an employee of the lender and the discharge relates to employment services performed) or any other factor not directly related to a decline in the value of the residence or to the taxpayer's financial condition (Sec. 108(h)(3)).

The exclusion also does not apply to a taxpayer in a Title 11 bankruptcy case; the regular Title 11 bankruptcy exclusion applies (Sec. 108(a)(2)(A)). And insolvent taxpayers other than those in a Title 11 bankruptcy case can elect to not have this special exclusion apply and instead rely on the Sec. 108(a)(1)(B) rules for insolvent taxpayers (Sec. 108(a)(2)(C)).

Observation: In some cases, taxpayers whose principal residences are foreclosed will be insolvent. The amount of discharge-of-indebtedness (DOI) income that is excludable from gross income by reason of insolvency is limited to the amount by which the debtor is insolvent immediately before the discharge transaction. This limitation does not apply in the case of this special principal residence exclusion.

Qualified principal residence indebtedness is debt that meets the Sec. 163(h)(3)(B) definition of acquisition indebtedness for the residential interest expense rules, but only with respect to the taxpayer's principal residence (i.e., it does not include second homes or vacation homes), and with a $2 million limit ($1 million for married filing separate taxpayers) on the aggregate amount of debt that can be treated as qualified principal residence indebtedness (Sec. 108(h)(2)).

Note: The Joint Committee on Taxation's explanation of the Mortgage Forgiveness Debt Relief Act of 2007, P.L. 110-142, provides that for purposes of this special exclusion, acquisition indebtedness includes refinanced debt to the extent the refinancing does not exceed the amount of the refinanced acquisition indebtedness (Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 110th Congress (JCS-1-09), p. 49 (March 2009)).

For purposes of these rules, a principal residence has the same meaning as under the Sec. 121 home sale gain exclusion rules (Sec. 108(h)(5)).

Most residential mortgages are classified as recourse debt. As such, a foreclosure involving recourse debt is treated as a deemed sale with proceeds equal to the lesser of fair market value (FMV) at the time of foreclosure or the amount of secured debt. If the amount of debt exceeds FMV, the difference is treated as DOI income if it is forgiven. Therefore, it is possible for a residential foreclosure transaction (involving recourse debt) to result in either a gain or loss from the sale of property and DOI income. However, only the portion of the transaction (if any) treated as DOI income is available for the special exclusion rule for qualified principal residence indebtedness; any income from the foreclosure treated as gain is not eligible for the exclusion rule.

Example: Exclusion for home mortgage debt discharge: T, who is not in bankruptcy and is not insolvent, owns a principal residence that is subject to a $300,000 mortgage secured by the residence. The original cost of the home was $270,000, and the lender foreclosed on the loan when the property's FMV was $280,000.

The foreclosure results in a taxable gain of $10,000 ($280,000 less $270,000) and DOI income of $20,000 ($300,000 less $280,000). The $10,000 gain must be recognized, but the $20,000 of debt discharge income is excluded.

In a rare case that a residential mortgage is nonrecourse, a foreclosure transfer is treated as a sale or exchange with the full amount of the debt as the amount realized, even if it is greater than the FMV of the property at the time of foreclosure. Therefore, there is no DOI income and the exclusion rule does not apply.

The basis of the taxpayer's principal residence must be reduced (but not below zero) by the amount of any income excluded under the special principal residence debt-exclusion rules (Sec. 108(h)(1)).

This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 21st edition (March 2020), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com).