In December 2007 President Bush enacted the Mortgage Forgiveness Debt Relief Act. This act was passed to assist homeowners who were faced with a tax on debt that was discharged by their mortgage lenders on short sales, deed in lieu of foreclosure, principal reduction and their foreclosed homes. The act was initially ending in 2009 but was extended through the end of calendar year 2012.
Example of Mortgage Forgiveness Debt Relief Act
The IRS considers any forgiven mortgage debt from a mortgage lender/bank to be taxable income. Let me explain further, consider your current outstanding balance on your mortgage loan is $300,000 and your home has a current market value of $175,000; in addition, let’s assume your lender would allow you to sell your home at $175,000 (this is a short sale), then your lender has forgiven the difference of $125,000.00 ($300,000 – $175,000). The difference would be considered taxable income. Depending on which tax bracket you are in, this could be a hefty taxable amount.
Requirements of the Act
To that end, the Mortgage Forgiveness Debt Relief Act suspended the forgiven difference and relieves homeowners the burden of paying a tax on debt that has been discharged. However, there are a few requirements that the government has placed on homeowners to participate in this program, namely:
- The relief is only for primary residences forgiven between January 1, 2009 through December 31, 2012.
- The relief provision is granted from calendar years 2007 through 2012 (with a possible extension to 2013).
- Exclusion from income tax is limited to $2 million a year on forgiven mortgage debt ($1 million if married filing separately).
The Mortgage Forgiveness Debt Relief Act also applies to debt reduced through mortgage restructuring, such as a principal reduction of your loan.
Solutions lenders tried to offer homeowners in lieu of the Mortgage Forgiveness Debt Relief Act is the HOPE for Homeowners Program
Any owner occupied home with a mortgage that was made after 2006, qualifies for a FHA guaranteed loan refinancing option at a fixed rate. However, there’s a catch to this provision. To qualify for the FHA loan, your current lender must agree and be willing to “write-off” 15% of the outstanding balance. That means, 85% of the outstanding balance, (including late fees, prepayment penalties and any other fees) will qualify as a restructured loan. Homeowners that elect to exercise this option must be willing to forfeit 50-100% of future equity. In addition, the homeowner may not partake in any home equity loan programs.
Obviously, this program was not well received by lenders and homeowners; therefore, this program was phased out as of June 10, 2011.
President Obama’s Call to Action for the Extension of Mortgage Debt Forgiveness Act
Fortunately our president has already requested an extension of the Act in his 2013 budget proposal and it is awaiting approval by the Members of Congress and the Senate. The expulsion of the tax on debt program has proven to be a huge success and homeowners will need to continue receiving this benefit if lenders expect acceptance of the short sale, principal reduction, and deed in lieu of foreclosure programs.
What Should You Do if You Received a Mortgage Debt Forgiveness from Your Lender?
If your lender has eliminated or reduced your debt, then they are required to provide a year end statement Form 1099-C “Cancellation of Debt”. Submit this form and fill out Form 982 Reduction of Tax Attributes Due to Discharge of Indebtedness and attach to your federal tax returns.