Short Sale Tax Info

Tax relief granted for forgiven debt, private mortgage insurance

Bush administration allows three-year window

Friday, December 21, 2007

By Matt Carter
Inman News

President Bush signed into law Thursday a bill creating a temporary tax break for homeowners who are able to persuade lenders to forgive part of their debt, and extends a tax deduction for some families with private mortgage insurance.

For the next three years, the IRS won't count as income debt forgiven by lenders when troubled borrowers negotiate short sales or workouts on their primary residence that involve forgiveness of part of their debt.

HR 3648, the Mortgage Forgiveness Debt Relief Act of 2007, also extends for three years a tax deduction allowing families earning $109,000 or less to deduct all or part their private mortgage insurance premiums from their taxable income -- which could save them an average of $350 a year.

In signing the bill, Bush said that not counting forgiven debt as income for tax purposes "will increase the incentive for borrowers and lenders to work together to refinance loans -- and it will allow American families to secure lower mortgage payments without facing higher taxes."

Richard Gaylord, president of the National Association of Realtors, said NAR has been advocating for such a change to the IRS tax code for nearly 10 years.

"We have always believed that it is clearly an issue of fairness and of not kicking people when they are down," Gaylord said in a statement.

As originally passed by the House Oct. 4 in a 386-27 vote, HR 3648 would have made the exemption permanent, and extended the tax deduction for private mortgage insurance until 2014. But those steps would have eliminated about $2 billion in tax revenue over a 10-year period, a problem the bill sought to offset tightening the rules for claiming a deduction on the sale of a second home.

The Bush administration argued that an exemption for forgiven debt should be temporary, and objected to provisions raising taxes on the sale of second homes. The Senate amended HR 3648 to address those concerns, and those changes were agreed to by House lawmakers in a Dec. 18 voice vote.

The deduction for private mortgage insurance allows families with an adjusted gross income of $100,000 or less to deduct all of their premium payments. Families with incomes up to $109,000 are eligible for partial deductions.

The private mortgage insurance deduction was first approved late in 2006 and initially applied only to the 2007 tax year. With the passage of HR 3648, the deduction has been extended to mortgages originated between 2007 and 2010.

Extension of the tax deduction for mortgage insurance premiums was part of the Mortgage Forgiveness Debt Relief Act of 2007 approved earlier this month by both the U.S. House of Representatives and the U.S. Senate.

Kevin Schneider, president of the Mortgage Insurance Companies of America (MICA), said borrowers who can claim the deduction could save an average of $350 a year.

The cost of private mortgage insurance -- required by most lenders on loans with less than a 20 percent down payment -- is going up, as companies that provide it raise their rates in the face of mounting losses.

PMI Group Inc. and MGIC Investment Corp. have raised or will soon raise rates for borrowers with lower credit scores and loan-to-value (LTVs) ratios above 95 percent. The companies have stopped insuring loans with LTVs above 95 percent for borrowers with credit scores below 620.

MICA reports there was $790.5 billion in primary private mortgage insurance in force as of October, up 17 percent from $650.2 billion a year ago. The number of primary insurance defaults in October hit 59,308, up 28 percent from the same month a year ago.

After the Short Sale: Taxing What Isn't There

By Lance Churchill

You've just spent several stressful weeks helping your beleaguered seller negotiate a short sale. You've helped demonstrate to the lender that the home's price has fallen and that to close the deal with the new buyer, the lender will have to forgive $10,000 of the seller's outstanding mortgage loan not covered by the sale proceeds. But you did it, and now everyone is happy. The buyer gets a home, the lender avoids a messy foreclosure, and the seller walks away with no further financial burdens. Well, not quite.

Whenever real estate is sold, whether in a standard transaction, a short sale or a foreclosure auction, there are potential tax consequences for the seller. In this little scenario, the seller may still owe taxes to Uncle Sam - both in the form of capital gains on the home and on the unpaid portion of the mortgage. Yet, too often, real estate practitioners are unaware of the tax liabilities arising from the cancellation of debt and fail to advise their clients accordingly. Don't make that mistake with your clients.

How Debt Forgiveness Works

With a short sale, the lender has three possible ways to handle the deficiency balance, which is the portion of the mortgage debt not covered by the sale of the home. First, the lender can attempt to collect the deficiency balance from the sellerafter the property has closed. Second, the lender may require the seller to sign an unsecured promissory note for the deficiency balanceas a condition of agreeing to the short sale. If the new note is for less than the balance of the original debt, the difference would be considered canceled, or forgiven, debt. Third, the lender may agree to cancel the entire deficiency balance.

On the surface, option three would be seem to be the best alternative for a seller. However, the IRS considers any canceled mortgage debt ordinary income. This means that the amount forgiven is taxed at the same rate - somewhere between 15 percent and 30 percent - as the sellers' salaries. In addition, because the IRS requires the lender to file a 1099-C form stating the amount of the canceled debt, Uncle Sam will have a record of the exact amount of the debt that was cancelled. A seller will also receive a copy of the 1099-C to use in filing income taxes. The seller's home state would also consider the cancelled debt as ordinary income.

4 Exceptions to the Rule

The IRS does recognize four situations in which cancellation of debt will not result in tax liability for the seller. A seller may avoid tax liability:

When the borrower receives a bankruptcy discharge and the deficiency was included in the bankruptcy
When the borrower is insolvent at the time of the cancellation of the debt. Insolvency would occur when a borrower's liabilities exceed assets. Note that seller would have to prove this insolvency to the IRS when filing a tax return.
When the debt was secured by a nonrecourse loan. Under a nonrecourse loan, the lender does not have the legal right to collect a deficiency judgment from any assets of the debtor not pledged to secure the loan. While most home mortgages are do not fall into this category, purchase money loans on a person's residence are nonrecourse in some states.
When the tax liability from the cancellation of debt on an investment property can be offset against other business liabilities and expenses. This exception does not apply to properties occupied as a residence by the mortgagor.

In many short sales, a seller would be able to qualify under the first two of these exemptions, especially since it was almost certainly necessary to show financial hardship in order to convince the lender to agree to a short sale. However, it is the seller's responsibility to notify the IRS why the amount in the 1099-C should not be counted as ordinary income. Otherwise, the IRS will consider the forgiven debt as income and penalize the seller for unpaid taxes.

What to Tell Clients

To ensure that your sellers don't run afoul of the IRS and blame you, you should notify all sellers in writing that they should seek professional tax advice regarding the possible tax consequences of selling their home.

While you certainly don't want to give specific tax advice, you should also alert short sellers to the basic facts about the tax consequences of short sales. With the current foreclosure crisis in this country, many, including NAR, are working to reverse this law. However, until that time, real estate sales associates must be aware of the potential tax issues for a seller in a short sale.

Editor's note: The NATIONAL ASSOCIATION OF REALTORS has long worked to change the tax laws and eliminate this "phantom tax" on income. Currently NAR is supporting the passage of S. 1394, the Mortgage Cancellation Tax Relief Act, which would repeal the law that requires home owners to pay taxes on forgiven debt for their principal residents as part of a short sale or foreclosure. Learn more about this topic at REALTOR.org.

About the Author: Lance Churchill is vice president of FrontLine Seminars , which educates and certifies real estate practitioners in foreclosure, preforeclosure, and short sales. Visit the company's Web site for information about courses on foreclosures and short sales. It's blog, FrontLineForeclosureForum.com , includes a discussion board for real estate practitioners working with foreclosures and short sales. Churchill can be reached at (208) 846-9644 or lance@frontlinescompanies.com.

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US Congress Moves a Step Closer Towards Amending Tax Code to Relieve Those in Foreclosure As the Ways and Means Committee Approves Mortgage Forgiveness Debt Relief Bill

WASHINGTON - The House Committee on Ways and Means unanimously approved H.R. 3648, the Mortgage Forgiveness Debt Relief Act of 2007, today in response to some of the tax issues that have arisen as a result of problems in the subprime mortgage market.

Under current law, debt forgiven following mortgage foreclosure or renegotiation is considered income for tax purposes, resulting in tax liability for individuals and families.

The legislation advanced by the Committee today would provide relief to those families by permanently excluding debt forgiven under these circumstances from tax liability. The bill would also help would-be homeowners secure their investments through a long-term extension of the tax deduction for private mortgage insurance, and would ease restrictions for qualifying as housing cooperative corporations.

Finally, the bipartisan bill would tighten requirements taxpayers must meet to exclude gain from the sale of certain homes that have been used as a vacation home or rental property.

Families dealing with the pain of a foreclosure should not have the double whammy of a large tax bill for terminating their mortgage through no fault of their own," said Ways and Means Committee Chairman Charles B. Rangel. I am pleased the Committee joined together to unanimously pass this critical legislation and I look forward to bringing this measure before the full House."

This proposed legislation is supported by both the National Association of Realtors and the Mortgage Bankers Association.

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Daily Real Estate News | September 27, 2007 Eliminating 'Phantom Tax' on Foreclosures Lauded

The NATIONAL ASSOCIATION OF REALTORS praised the House Ways and Means Committee for taking positive action this week on the Mortgage Cancellation Tax Relief Act, H.R. 3648. Since the early 1990s, NAR has pursued repealing the law, which forces individuals to pay an income tax on mortgages that have been forgiven or foreclosed.

"NAR is encouraged by today's House Ways and Means Committee vote," says NAR President Pat V. Combs of Grand Rapids, Mich., and vice president of Coldwell Banker-AJS-Schmidt. "Changing the IRS code for these situations will relieve a tax burden for families who are already in financial distress and are most likely unable to pay additional taxes."

With many families affected by resetting interest rates on subprime mortgages and the ongoing rise in foreclosures, NAR has been working to help more homeowners and their families keep their homes. "Clearly it is unfair to tax people on phantom income when they most likely have no cash with which to pay that tax," says Combs. "Realtors don't just sell homes; we build communities, and NAR is committed to efforts that will help make the nightmare of losing a home less burdensome for families."

The current tax code requires a lender who forgives debt to provide a Form 1099 to the IRS stating the amount the borrower has been forgiven. This disclosure applies whether a short sale, foreclosure, deed in lieu of foreclosure or any similar arrangement relieves the borrower of the obligation to pay some portion of his or her debt. If the property is sold at foreclosure or is sold for less than the amount borrowed, that difference is considered income and is subject to the tax.

H.R. 3648 would ensure that any mortgage debt secured by a principal residence will not be taxed. "NAR stands strongly with Chairman Rangel, D-N.Y., and Ranking Member McCrery, R-La. Their relief proposal addresses a fundamental unfairness that affects the lives of those who find themselves in truly unfortunate circumstances. We must all work together to prevent the dream of homeownership from becoming a nightmare," said Combs.

The legislation includes a provision to safeguard against abuses. The provision, similar to one that already exists for commercial real estate owners, would treat commercial and residential property equally. In addition, NAR supports the proposed offset, which tightens the requirements for taking advantage of some tax benefits while retaining all of them.