Exclusion for income from discharge of indebtedness: mortgage debt forgiveness.

• Author: Russo, Charles J.

The Mortgage Forgiveness Debt Relief Act of 2007, P.L. 110-142, provides an exclusion from income for the discharge of indebtedness (DOI) on a qualified principal residence. The exclusion is effective for home mortgage debt discharged between January 1, 2007, and December 31, 2012 (Sec. 108(a)(1)(E)). (The Emergency Economic Stabilization Act of 2008, P.L. 110-343, extended the exclusion from December 31, 2009, to December 31, 2012.) The amount excluded under this exception is used to reduce the taxpayer's basis in the residence, but not below zero (Sec. 108(h)(1)).

Income from DOI in General

In general, income from debt forgiveness is excluded under Sec. 108 if the discharge occurs as part of a title 11 bankruptcy, when the taxpayer is insolvent, or when the debt is from "qualified farm indebtedness" (Sec. 108(a)(1)). Prior to 2007, forgiveness of home mortgage debt outside bankruptcy or insolvency resulted in income recognition.

Example 1: T, a taxpayer who is not in bankruptcy or insolvent, owns a principal residence with a $400,000 mortgage, which is foreclosed. The home is then sold for $300,000 in satisfaction of the debt. This results in $100,000 of DOI income includible in T's gross income. Likewise, if T and the lender restructure the loan in a workout by reducing the principal to $300,000, T has $100,000 of DOI income includible in gross income.

Due to the mortgage meltdown, Congress alleviated the harshness of this income recognition by adding the exclusion for income from DOI for home mortgage debt discharged from January 1, 2007, to December 31, 2012 (Sec. 108(a)(1) (E)). In general, when income from DOI is excluded under Sec. 108, various tax attributes including basis in properties, net operating losses (NOLs), passive activity losses (PALs), and credit carryovers must be reduced. Therefore, for some taxpayers, application of Sec. 108 results in a deferral rather than an exclusion of income. Other taxpayers, however, who do not have sufficient attributes (NOLs, PALs, etc.) to absorb the full amount of cancellation of debt (COD) excluded may potentially achieve a permanent exclusion of income.

Exclusion for Discharge of Home Mortgage Indebtedness

DOI income includes discharge of an individual's home mortgage indebtedness. However, DOI income of a qualified principal residence is excluded from gross income for debt discharges from January 1, 2007, to December 31, 2012 (Sec. 108(a)(1)(E)). The exclusion applies whether the taxpayer restructures the debt on the principal residence or the debt is reduced because of foreclosure and sale (IR-2008-17). The exclusion is claimed on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

The exclusion applies only to qualified principal residence indebtedness, which is the same as acquisition indebtedness as defined for purposes of the home mortgage interest deduction. Acquisition indebtedness generally includes debt for acquiring, constructing, or substantially improving a principal residence. While the maximum amount of debt that can be used in calculating the home mortgage interest deduction under Sec. 163 is $1 million ($500,000 for married taxpayers filing separately), the maximum amount of qualified principal residence debt for this exclusion is $2 million ($1 million for married taxpayers filing separately) (Sec. 108(h)(2)). Debt used to refinance...