President Bush signed a great deal of legislation late in 2007. Some legislation was for mortgage relief in response to the all too familiar subprime mortgage problems. With the falling property values that we have seen since 2008, this law is most useful to taxpayers experiencing foreclosure and mortgage restructuring. This legislation was originally set to expire after 2012, but has been extended by the American Taxpayer Relief Act through 2013.
This article does not apply to Title 11 bankruptcy or insolvency, as debts in those situations were not considered taxable before this legislation.
Normally when debt is forgiven, either wholly or partially, the amount that is forgiven is considered taxable income to the person responsible for the debt. Debt forgiveness is “phantom income,” as there is no cash received. It is merely a reduction of a future obligation. This was often a problem for a taxpayer who did not have the cash to make mortgage payments, much less pay tax on debt forgiveness.
Relief is now available to individuals and businesses that are not C-corporations.
In the case of individuals, any forgiven debt that is “qualified principal residence indebtedness” is excludible from gross income up to $2 million ($ 1 million if married filing separate). Qualified principal residence indebtedness must be incurred only with respect to the taxpayer’s principal residence.
Example: A taxpayer, who is not in bankruptcy and is not insolvent, owns a principal residence subject to a $200,000 mortgage debt for which the taxpayer has personal liability. The creditor forecloses and the home is sold for $180,000.
Prior to this legislation, the taxpayer had $20,000 of debt discharge income. The result was the same if the creditor restructured the loan and reduced the principal amount to $180,000.
The exclusion does not apply to a second mortgage or a home equity loan unless those loans were also used to acquire, construct or substantially improve the taxpayer’s principal residence. Refinancing applies to the extent of the original debt. Cash received from financing does not qualify.
However, this is not necessarily a tax-free transaction. It may be merely tax-deferred. Any debt forgiveness excluded from income reduces the owner’s cost basis in the residence, which in turn will increase the capital gain on the future sale of the house. Since current law provides a capital gain exclusion of up to $500,000 ($250,000 if married filing separate) on the sale of a primary residence, most taxpayers will never actually pay tax on their debt forgiveness.
In the case of businesses, the situation is similar. Many businesses are “upside down” on real estate holdings, and the banks are forced to write down these mortgages by government regulators. The business is then hit with a tax bill on the debt forgiveness that they can only pay by selling that real estate in a depressed market.
Now with the recent legislation, if a business has basis in the property, the debt forgiveness can instead reduce the taxpayer’s basis in the real estate. Debt forgiveness income is only excludible to the extent that the mortgage exceeds the fair market value (FMV) of the property. This applies regardless of the number of mortgages on that property.
Example: ABC, Inc. (an S-corporation) owns a building with 2 mortgages, a primary for $110,000 and a second for $90,000. The building is worth $150,000. ABC negotiates to reduce their second mortgage to $30,000, resulting in a $60,000 discharge of indebtedness. Assuming ABC, Inc. has sufficient basis in the property to absorb the reduction due to the discharge, ABC may exclude $50,000 from gross income ($200,000 in total mortgages – $150,000 FMV). The remaining $10,000 is included in gross income.
So, if you are facing foreclosure or mortgage reduction, make sure that you are not mistakenly being taxed on your debt forgiveness income. If you would like more information regarding this topic or any other tax related issue, please contact Henssler Financial at 770-429-9166 or experts@henssler.com.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
