Reducing Foreclosure Tax Consequences, Pt. 2

By October 23, 2009 Individuals

According to the Mortgage Bankers Association, 1 out of every 200 homes will be foreclosed upon.  In an effort toward reducing foreclosure tax consequences associated with the cancellation of debt that often times accompany foreclosure, Congress passed The Mortgage Forgiveness Debt Relief Act of 2007 (“Mortgage Act”).  The Mortgage Act provides taxpayer relief by excluding cancellation of debt income on a primary residence from gross income.

Taxpayers can exclude from gross income a discharge (in whole or in part) of qualified principal residence indebtedness before January 1, 2013.  The exclusion applies where a taxpayer restructures their acquisition debt on a principal residence or loses their principal residence in a foreclosure.  The exclusion does not apply to a taxpayer in a Title 11 bankruptcy case; as the regular Title 11 bankruptcy exclusion takes precedence.  Insolvent taxpayers other than those in a Title 11 bankruptcy case can elect to use the insolvency exception instead of the qualified principal exception.  However, taxpayers choosing the insolvency election should be aware that the amount of discharge indebtedness income that is excludable from gross income by reason of insolvency is limited to the amount the debtor is insolvent immediately before the discharge transaction.  Therefore, the qualified principal residence exclusion may prove to be more advantageous as the insolvency limitation does not apply.

The most important aspect of the qualified principal residence exclusion is that it applies only to that portion of qualified principal residence indebtedness that is considered acquisition indebtedness.  Acquisition indebtedness is debt used to buy, build, or substantially improve the taxpayer’s principal residence and must have been secured by that residence.  Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualifies for the exclusion.  However, proceeds of refinanced debt used for other purposes do not qualify for the exclusion and the exclusion amount is limited to the old mortgage principal, just before the refinancing.  In addition, there is a $2 million limit on the aggregate amount of debt that can be treated as qualified principal residence indebtedness.

Details on the completion of the tax forms and how to report on your tax return to follow….. please see Reducing Foreclosure Tax Consequences, pt. 3.

For more information regarding Reducing Foreclosure Tax Consequences please see Reducing Foreclosure Tax Consequences, Pt. 1.