WASHINGTON ” With the Obama administration and private lenders now actively considering mortgage principal-reduction programs to help financially distressed homeowners, the Internal Revenue Service has issued a new advisory to taxpayers who receive or seek to receive such assistance if it's offered.
The IRS gets involved in mortgage principal write-downs because the federal tax code generally treats any forgiveness of debt by a creditor in excess of $600 as ordinary taxable income to the recipient.
However, under legislation that took effect in 2007, certain home mortgage debt cancellations â€” such as through loan modifications, short sales or foreclosures â€” may be exempted from tax treatment as income.
Sheila Bair, chairman of the Federal Deposit Insurance Corp., recently confirmed that her agency is working on a new program to expand the use of principal mortgage reductions to keep underwater borrowers out of foreclosure.
Major banks and mortgage companies have preferred monthly payment reductions and other loan-modification techniques over cuts of principal balances, but a handful have made limited use of the concept.
One of the largest servicers of subprime home loans, Ocwen Financial of West Palm Beach, Fla., has strongly advocated principal reductions to keep people out of foreclosure, and claimed broad success with them.
Ron Faris, president of Ocwen, testified recently to a congressional subcommittee that borrowers with negative equity are as much as twice as likely to re-default after a standard, payment-reduction loan modification than those who receive partial forgiveness on their principal debt.
But what are the tax implications when your lender essentially says: OK, we recognize you're underwater, maybe you're thinking about walking away, and we're going to write off some of what you owe to keep you in the house?
IRS guidance issued March 4 spelled out, step by step, how financially troubled and underwater borrowers can qualify for tax relief when a lender agrees to lower their debt.
Here are the basics, should you be considering a short sale or loan modification involving principal reduction.
To begin with, be aware that the federal tax exclusion only applies to mortgage balances on your principal residence â€” your main home â€” and not on second homes, rental real estate or business property.
The maximum amount of forgiven debt eligible under the law is $2 million for married taxpayers filing jointly and $1 million for single filers.
But there are some potential snares: Your debt reduction can only be for loan amounts that you've used to "buy, build or substantially improve your principal residence." This includes refinancings that increased your total mortgage debt attributable to renovations and capital improvements of your house.
But if you used the proceeds for other personal purposes, such as to pay off credit-card bills, buy cars or invest in stocks, the mortgage debt attributable to those expenditures is not eligible for tax exclusion.
Say you refinanced and used some of the proceeds to purchase a boat and pay off business debts. Those expenditures would not qualify for the tax-relief provisions because they were not intended to substantially improve your house or build a residence.
In all refinancings, make sure you can document where the money flowed.
When your lender formally forgives all or part of your mortgage balance, the lender is required by law to issue you an IRS Form 1099-C, a "Cancellation of Debt" notice, which is also sent to the IRS.
The form shows not only the amount of debt discharged but the estimated fair-market value of the house securing the debt as well.
A few other noteworthy features of the IRS rules: If you've been foreclosed upon or you do a short sale and you lose money in the process, don't claim a tax loss on your federal filing. The IRS will turn you down.
However, if you go to foreclosure and your lender agrees to cancel all or part of the unpaid mortgage balance as part of the deal, then you can file for an exemption from the IRS.
What if your lender reduces the debt on your house but you continue to own the property and live in it? There's a tax wrinkle in the fine print: The IRS will require you to reduce your "basis" in the house your "cost" for tax purposes by the amount of the forgiven debt.
But that's not likely a big concern for most homeowners digging their way out of the bust.
Finally, if you want to claim the debt forgiveness exemption, download IRS Form 982 (available at www.irs.gov) and attach it to your return for the year in which the debt was forgiven. And don't assume this tax-code benefit to homeowners will be around forever. It expires at the end of 2012.