Contemplating A Mortgage Modification Or Short Sale?

The recent CCH User Conference in San Diego presented a variety of tax implications on home foreclosures in the US that should not only be taken seriously, they also require immediate action. Any homeowner who is considering applying for a mortgage modification or who is looking to sell their home in a short sale in order to avoid foreclosure should get started as soon as possible, either by meeting with their lender to discuss their modification options, or by consulting with a reputable short sale real estate agent.

In a nutshell, 97 % of Americans own homes that are worth much less than what they were worth at the time of purchase, and a large majority of homeowners are considering some form of modification with their mortgage lenders. Additionally, many homeowners are considering short sales as well as just walking away with a foreclosure in today’s troubled times.

What homeowners need to be aware of is that any time a mortgage is reduced or modified, the borrowers are required to acknowledge cancellation of indebtedness (COD) income under Section 61(a)(12) to the degree of the forgiveness of debts. Likewise, if the property is sold during foreclosure or as the result of a short sale and the primary mortgage is recourse (meaning the borrower is responsible responsibility for any remaining loan debt after the sale), this COD income will not be treated as financial gain from the sale of the home, and will not be eligible for exclusion under Section 121. This provision allows for married taxpayers to exclude from taxation up to $500,000 of financial profit on the sale of a home, providing that they have owned the home and it has been their main principal residence for at least two of the last five years. The end result in this is that a certain amount of COD income may be recognized.

A good example may go something like this: A borrower owns a primary residence with an initial value of $500,000 that is dependent on a recourse mortgage with a total balance of $400,000. When the property goes down in value to the amount of $300,000, the borrower and lender may agree to enter into a short sale of the home. The typical result will be that the borrower will sell their home to an unassociated buyer for $300,000. The borrower will forward the $300,000 to the lender in order to settle the total debt of $400,000, which in turn will leave the borrower with a deficiency of $100,00. There is a possibility that the lender will forgive this remaining deficiency, and if forgiveness occurs, the borrower can now recognize the $100,000 as COD income.

At the start of the real estate crisis, Congress realized that they had to step in and do something to assist the homeowners who were dealing with foreclosures as well as pursuing loan modifications. They recognized that it was simply unfair to charge a tax to homeowners on COD incomes when they did not have the means to service their home mortgages. There have always been certain exclusions under Section 108, but they were only allowed to homeowners that were financially bankrupt or insolvent.

The bursting of the real estate bubble and its aftermath resulted in Congress enacting Section 108(a)(1)(E), which states that if the taxpayer is neither insolvent or bankrupt, they are still allowed to exclude COD income up to $2,000,000 that is either partly or completely related to the discharge of qualified principal residence indebtedness. This exclusion stands whether a borrower modifies their loan, sells, their home in a short sale, or loses their home to foreclosure.

For the purpose of this article:

Qualified principal residence indebtedness is defined as any financial debt that meets the Section 163(h)(3)(B) explanations of acquisition indebtedness for the residential interest expense rules, but this is only with respect to the taxpayer’s principal residence, (i.e., vacation homes and additional homes are excluded), and with limit of $2 million, and a $1 million limit for married taxpayers that file separately, on the overall amount of debt that can be considered qualified principal residence indebtedness. Basically, the debt must have been obtained in order to acquire, build, or improve the home and the property must secure the debt.

Acquisition indebtedness also includes refinanced debt, but only to the extent that the refinancing amount will not exceed the total amount of the refinanced acquisition indebtedness.

While potential borrowers and homeowners who are facing a foreclosure and considering a short sale may read this article and wonder how it will help them, the answer is simple: the exclusion is getting ready to expire on December 31, 2012. There is always the possibility of an extension through Congress, which will allow for an extended expiration date of the Section 108 exclusion, but past experience has shown that the chance of that happening before the end of the year is minimal. That is why it is important for homeowners seeking debt modification or pushing for a short sale to act as soon as possible, as there is still some time left. By working with lenders and doing what they can to take advantage of the Section 108 exclusion while they still can, homeowners can definitely benefit.