The Mortgage Forgiveness Debt Relief Act of 2007.

• Author: Jones, Lynn Comer
• Position: Tax and debt forgiveness issues

EXECUTIVE SUMMARY

* Under the act, a taxpayer may exclude from income $2 million ($1 million if married filing separately) in principal mortgage indebtedness forgiveness on a qualified principal residence during 2007, 2008, and 2009.

* The mortgage interest deduction for mortgage insurance premiums is extended through December 31, 2010.

* State and local tax benefits and qualified payments to members of qualified volunteer emergency response organizations are excluded from income through December 31, 2010.

* $500,000 of capital gain income from surviving spouse qualified home sales can be excluded from income beginning January 1, 2008.

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Early in the decade, lenders were willing to loan money to home buyers with bad or no credit (subprime loans). Lenders were hedging losses (i.e., from future foreclosures) on the significant appreciation the homing market was experiencing. In addition, lenders were enticing borrowers with adjustable-rate mortgages (ARMs). ARMs, with interest rate adjustments that are tied to the federal funds rate (FFR) (the rate at which banks make unsecured loam to each other), are an excellent financing tool when the market conditions are right (i.e., the FFR is decreasing). However, in 2003 the annual effective FFR was a mere 1.13%, the lowest of any year in the Federal Reserve's published historical data (going back to 1955). (1) Thus, the market was moving in a direction that was detrimental to ARMs. As the FFK increases, homeowners' mortgage payments begin to escalate and defaults increase.

These conditions were the catalyst for the subprime mortgage crisis. Subprime mortgage borrowing nearly tripled in 2004 and 2005. However, with the subsequent decline in house prices, higher FFR, and slower economic growth, the delinquency rate among subprime borrowers has risen dramatically. The rise is attributable mostly to borrowers with ARMs. (2)

In response to the subprime mortgage crisis, the Mortgage Forgiveness Debt Relief Act of 2007, P.L. 110-142 (MRA), was signed into law on December 20, 2007. This act excludes from income the discharge of qualified principal residence indebtedness. Its discharge provisions are temporary and apply to discharges during 2007, 2008, and 2009.

The act also made several other important changes, including:

* Allowing surviving spouses to qualify for the $500,000 exclusion for capital gain on the sale of a principal residence;

* Extending the mortgage interest deduction for mortgage insurance premiums;

* Adding qualification criteria for cooperative housing corporations; and

* Excluding from income certain state and local tax benefits of volunteer firefighters and emergency responders.

Treatment of Discharge of Indebtedness

Sec. 61 (a)(12) requires income recognition for discharge of mortgage indebtedness. However, certain exceptions exist for discharges in the case of bankruptcy (Sec. 108(a)(1)(A)) or insolvent taxpayers (Sec. 108(a)(1)(B)). Bankrupt taxpayers may exclude income as long as the debt discharge is part of a court-approved bankruptcy plan (Sec. 108(d)(2)). Insolvent taxpayers (whose liabilities exceed the fair market value (FMV) of their assets) avoid income recognition as long as the discharge amount does not exceed the borrowers' insolvency position. (3)

The tax effect of debt discharge is different for solvent taxpayers, those with personal debt (credit cards and mortgage) that does not exceed their home value plus other assets. Solvent taxpayers recognize ordinary income on canceled recourse debt (4) to the extent it exceeds the value of the assets (typically the FMV of the home) given to satisfy the discharge. (5) Recourse debt is the typical lending arrangement for mortgages. In the past decade, lenders have allowed some buyers to borrow 95% to 100% of the home's purchase price. Moreover, the lending arrangements typically consisted of first mortgages at 80% with the remaining 15% or 20% financed via second mortgages (with higher fixed interest rates) or equity lines of credit.

Currently, with home prices decreasing, homes may have FMVs less than the associated mortgages. Foreclosures on high loan-to-value recourse debt make the effects of the historical debt forgiveness provisions even worse. In addition to losing their homes, homeowners might have to recognize ordinary income equal to the excess debt (i.e., debt less the home's FMV).

Mortgage Relief

Solvent taxpayers benefit from the MRA because they are not eligible for the insolvency exclusion (Sec. 108(a) (1)(B)).The act excludes qualified principal...