What am I missing here?

  • Thread starter Stuart A. Bronstein
  • Start date

S

Stuart A. Bronstein

Am I missing something concerning the Mortgage Forgiveness Dept Relief
Act of 2007? The upshot is that on foreclosure of someone's residence,
debt not required to be repaid is not considered income as long as the
debt was used to purchase or fix up the house (directly or indirectly,
meaning it went into the basis of the house).

It seems to me that act really had no real effect with respect to
forgiveness of debt income on home mortgages. There should only be
income to the extent the forgiven debt exceeds the debtor's basis in
the property. And if the act only applies to debt that went into or
increased the basis, none of that forgiven debt would have had to be
recognized as income in any case.

So what was the purpose of the statute really? Does it have an actual
effect?

Thanks for your insight.

Stu
 
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M

Mark Bole

Stuart said:
Am I missing something concerning the Mortgage Forgiveness Dept Relief
Act of 2007? The upshot is that on foreclosure of someone's residence,
debt not required to be repaid is not considered income as long as the
debt was used to purchase or fix up the house (directly or indirectly,
meaning it went into the basis of the house).

It seems to me that act really had no real effect with respect to
forgiveness of debt income on home mortgages. There should only be
income to the extent the forgiven debt exceeds the debtor's basis in
the property.
That's what you are missing. Before this act, the full amount of
canceled debt was taxable income, now it's not (for three years only,
2007-2009). The amount excluded from income under this law is used to
reduce the basis in the property. The gain if any due to this reduced
basis, however, typically will fall under the normal Sec. 121 exclusion
rule.
And if the act only applies to debt that went into or
increased the basis, none of that forgiven debt would have had to be
recognized as income in any case.
Wrong, prior to the act there was no special rule regarding acquisition
debt on a principal residence. It was all still just cancellation of
debt income.
So what was the purpose of the statute really? Does it have an actual
effect?
One way to think of it, is that it has the effect of making short sale
or foreclosure of a house with recourse debt behave as if it were
non-recourse debt for tax purposes.

For states like California which did not conform to the federal law, any
cancellation of debt income excluded on the federal return must be
added back for the state return.


-Mark Bole
 
S

Stuart A. Bronstein

Alan said:
Stuart A. Bronstein wrote:
Your error is where you say "There should only be
income to the extent the forgiven debt exceeds the debtor's basis
in the property."
You seem to have confused two issues: Debt cancellation and gain
or loss on the sale of real property.
Perhaps. But it seems to me that in the case of, say, a single
purchase money loan, when the home is foreclosed on, it's in effect a
sale of the home back to the bank for the amount of the outstanding
debt. In that case how can there be debt cancellation income without
gain? That would be like saying that anyone who sells a house with a
mortgage on it has income in addition to their gain.
If you have a recourse loan on your home and debt is forgiven,
you normally have debt cancellation income.
I guess that's part of my problem with this - exactly when is debt
"forgiven"? If someone gives value in exchange for cancellation of
debt, for me that's an exchange and there's only tax if there is
gain.
IRS Pub 4681 (Canceled Debts, Foreclosures, Repossessions and
Abandonments) has a very good explanation and examples of the tax
consequences relating to the Pub subject.
Thanks.

Even that publication says there should only be cancellation of debt
income if the amount owed is less than the fair market value of the
property. So why is there no offsetting loss on the "sale" of
property for less than basis? You may not be able to deduct the loss
from taxes, but shouldn't it be allowed to offset any gain?

Stu
 
S

Stuart A. Bronstein

Mark Bole said:
Stuart A. Bronstein wrote:

That's what you are missing. Before this act, the full amount of
canceled debt was taxable income, now it's not (for three years
only, 2007-2009). The amount excluded from income under this law
is used to reduce the basis in the property. The gain if any due
to this reduced basis, however, typically will fall under the
normal Sec. 121 exclusion rule.
That might have been the theory. But as I said to Alan, it seems to
me that any foreclosure (or equivalent) is in effect a sale to the
lender for the amount of the outstanding debt. Whenever you sell a
property subject to a mortgage, the debt is "cancelled" but without
incurring tax on that "gain."

Why should it be different when the lender buys it from the debtor?
Wrong, prior to the act there was no special rule regarding
acquisition debt on a principal residence. It was all still just
cancellation of debt income.
I understand that. But how could it be taxable if the "gain" was
offset by the debtor's basis on the property?
One way to think of it, is that it has the effect of making short
sale or foreclosure of a house with recourse debt behave as if it
were non-recourse debt for tax purposes.
Say you have a house with a basis of $100,000 secured by a loan of
$100,000. You do a short sale for $80,000. You technically have
cancellation of debt income of $20,000. But you also have a loss of
$20,000. Why doesn't the loss offset the gain?

Stu
 
T

TheMightyAtlas

Am I missing something concerning the Mortgage Forgiveness Dept Relief
Act of 2007?  The upshot is that on foreclosure of someone's residence,  
debt not required to be repaid is not considered income as long as the
debt was used to purchase or fix up the house (directly or indirectly,
meaning it went into the basis of the house).

It seems to me that act really had no real effect with respect to
forgiveness of debt income on home mortgages.  There should only be
income to the extent the forgiven debt exceeds the debtor's basis in
the property.  And if the act only applies to debt that went into or
increased the basis, none of that forgiven debt would have had to be
recognized as income in any case.

So what was the purpose of the statute really?  Does it have an actual
effect?

Thanks for your insight.

Stu
A foreclosure or short sale involving a debtor who is not otherwise
insolvent would normally be seen by the IRS as a transaction with two
components:

- A sale at a price probably below the basis, but this generates a non-
deductible personal loss.
- Debt forgiveness which results in taxable income for the amount that
the debt was greater than the sales proceeds.

The Act of 2007 basically makes the debt forgiveness non-taxable to
the extent that the borrowing was for purchase money or home
improvement.

Say you bought the house for $200k, borrowed $150k and then when the
market boomed, you refinanced and borrowed another $150k, because your
house could appraise at $350k without any improvements. You spent the
$150 on an investment property, college tuition for the kids, travel
around the world for six months etc. Then the market crashes, you have
a short sale for $250k, and the bank forgives $50k. You still pay tax
on the $50k.

But if you bought a house for $350k, borrowed $300k, and then the
market crashes, you have a short sale for $250k, and the bank forgives
$50k. Without the Act of 2007 you would have $50k in debt forgiveness
income (taxable) and a non-deductible loss of $100k, which may very
well mean a tax bill of $35k. If you weren't insolvent before
(excluding the mortgage) you may very well be insolvent now, and be
driven into bankruptcy. Then things get worse because your tax debt
isn't discharged in bankruptcy either. Your better option would have
been to forgo the short sale, and go into foreclosure and bankruptcy
in the first place. This is a worse outcome not only for you but from
the point of view of the economy as a whole. There is a deadweight
economic loss from the foreclosure compared with a short sale, but the
tax consequences make the short sale worse for the homeowner.
 
M

Mark Bole

Stuart A. Bronstein wrote:
[...]
That might have been the theory. But as I said to Alan, it seems to
me that any foreclosure (or equivalent) is in effect a sale to the
lender for the amount of the outstanding debt.
Only if it's a non-recourse loan. Remember, just because your property
is foreclosed doesn't mean the bank has stopped going after you for the
rest of the money if it's a recourse loan. Cancellation of debt can
take place quite some time after the foreclosure sale.


Whenever you sell a
property subject to a mortgage, the debt is "cancelled" but without
incurring tax on that "gain."
"canceled" = "forgiven", not "paid off".


[...]
Say you have a house with a basis of $100,000 secured by a loan of
$100,000. You do a short sale for $80,000. You technically have
cancellation of debt income of $20,000. But you also have a loss of
$20,000. Why doesn't the loss offset the gain?
As someone else already pointed out, the loss is a non-deductible
personal loss.

-Mark Bole
 
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M

Mark Bole

Stuart said:
Perhaps. But it seems to me that in the case of, say, a single
purchase money loan, when the home is foreclosed on, it's in effect a
sale of the home back to the bank for the amount of the outstanding
debt. In that case how can there be debt cancellation income without
gain? That would be like saying that anyone who sells a house with a
mortgage on it has income in addition to their gain.


I guess that's part of my problem with this - exactly when is debt
"forgiven"? If someone gives value in exchange for cancellation of
debt, for me that's an exchange and there's only tax if there is
gain.
The terminology confuses me some times. To be precise, with a
non-recourse loan, the amount of debt canceled becomes the "sales price"
considered to have been received, and there is no *income* from
cancellation of debt (although there will usually be a gain or loss on
the "sale" of the property). With a recourse loan, the sales price
considered to have been received is the FMV, and if the amount of debt
canceled is more than the FMV, the difference is taxable income due to
cancellation of debt.

Thanks.

Even that publication says there should only be cancellation of debt
income if the amount owed is less than the fair market value of the
property.
I believe that is "more than", not "less than". Or give us a page
number in the PDF file to refer to. But otherwise, yes, cancellation of
recourse debt is taxable income to the extent it exceeds the FMV of the
property surrendered. Again, cancellation of non-recourse debt does not
normally lead to any taxable COD income.

As I said before, in reply to your original post, the 2007 tax law had
the effect of making cancellation of recourse debt that met the
requirements end up being treated like non-recourse debt for this
purpose (I'm oversimplifying, but the end result looks the same for tax
purposes). The canceled recourse debt that did not meet the
requirements (acquisition debt on primary residence) still can generate
COD income.

So why is there no offsetting loss on the "sale" of
property for less than basis? You may not be able to deduct the loss
from taxes, but shouldn't it be allowed to offset any gain?

The gain or loss on the "sale", and income from cancellation of debt,
are two different things. The latter is not gain from sale of property.

As we know, the gain on sale of personal residence gets favorable
treatment under both Sec 121 and long-term capital gains tax rates.
Income from cancellation of debt gets no such treatment. The 2007 law
moves some income out of the latter category into the former, under the
right limited conditions -- similar to what would happen with a
non-recourse loan even before the 2007 law.

-Mark Bole
 
M

Mark Bole

Mark said:
For states like California which did not conform to the federal law, any
cancellation of debt income excluded on the federal return must be
added back for the state return.
....and then still possibly eligible for the insolvency exclusion, IIRC.

-Mark Bole
 
K

Katie

...and then still possibly eligible for the insolvency exclusion, IIRC.

-Mark Bole

Actually, California has partially conformed to the federal Mortgage
Forgiveness Debt Relief Act of 2007 (SB 1055, Ch. 282, Stats. 2008).
2007 returns can be amended to claim refunds available under the new
law.

Differences between California and federal law are the following:

· "Qualified principal residence indebtedness" is limited to $800,000
($400,000 MFS) as opposed to $2 million/$1 million federal.
· The maximum COD income exclusion is limited to $250,000 ($125,000
MFS); there is no maximum for federal purposes.
· The California exclusion is available for 2007 and 2008 only, not
2009.

For federal purposes, a taxpayer may elect to use the insolvency
rules under IRC Sec. 108 rather than the principal residence exclusion
rules. A different election may be made for California than for
federal purposes.

Katie in San Diego
 
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M

Mark Bole

Mark Bole wrote:

Heh... it's so slow around here this time of year, I have to correct my
own mistakes.
Before this act, the full amount of
canceled debt was taxable income, now it's not (for three years only,
2007-2009).
"The federal law previously covered debt forgiven from 2007 through
2009. On October 3, 2008, the Emergency Economic Stabilization Act of
2008 (H.R. 1424) extended the federal period through 2012."

For states like California which did not conform to the federal law, any
cancellation of debt income excluded on the federal return must be
added back for the state return.
California as of now partially conforms, only for years 2007-2008 and
with lower limits.

http://www.ftb.ca.gov/aboutFTB/newsroom/Mortgage_Debt_Relief_Law.shtml

-Mark Bole
 

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