Mortgage Forgiveness Debt Relief Act of 2007

• Author: Curt Hochbein
• Position: J.D., 2010, Capital University Law School
• Pages: 889-920

MORTGAGE FORGIVENESS DEBT RELIEF ACT OF 2007

CURT HOCHBEIN*

I. INTRODUCTION

Owning a home has transformed from being part o f the “American

Dream” to what many people, including our legis lators, see as the

“American Right.” Throug hout the 1990s and early 2000s, Ameri ca’s

housing market experienced an unp recedented b oom fueled largely by a

decrease in the regu lations of lending agencies.1 The d ecrease in

regulations caused an increase in loan s given to borrowers whose job

status, financial status, and credit rating traditionally would have p revented

them from obtaining a mortgage or at least one as large as they received .2

Moreover, lenders , in an effort to provide more people wi th the “American

Dream,” began providing ad justable rate mortgages (ARMs) and interes t

only mortga ges.3 These mortg ages reduced the monthly paymen t for

borrowers, so they could afford bigger, more expensive homes in nicer

neighborhoods.4 By 2006, the market reached its peak, and the interest

rates o n ARMs began adjusting, causing h igher prices for borrowers who

were already stretched thin making payments at the lo wer interest rate.5

Since 2006, America has seen its real est ate and financial markets

spiral out of control, bringing the highest rates o f foreclosu re since the

Copyright © 2010, Curt Ho chbein.

* J.D., 2010, Capital University Law School. I would like to thank my wife for all of

her support and inspiration.

1 See The H ousing Decline: Extent of the Problem and Po tential Remedies: Hearing

Before S. C omm. on Finance, 110th Cong. 5–6 (2007) [hereinafter H ousing Decline

Hearing] (testimony of Morris A. Davis, Professor of Econo mics, University of

Wisconsin).

2 Id.

3 See id. at 3–4 (testimony of Jack Kemp, Principal, Kemp Partners).

4 Evolution of an Economic Crisis?: The Subprime Lend ing Disaster and the Threat to

the Broader Economy: Hearing Before Joint Economic Comm., 110th Cong . 77–79 (2007)

[hereinafter Sub prime Lending Hea ring] (statement of Robert J. Shiller, Professor of

Economics and F inance, Yale University) (discussing the “social epidemic of op timism for

real estate”).

5 Housing De cline Hearing, supra note 2, at 3–4 (testimony of Jack Kemp, Princip al,

Kemp Partners).

890 CAPITAL UNIVER SITY LAW REVIEW [38:889

Great Depression.6 In response to rising home foreclosures and sinking

home and land v alues, seemingly with no end in sight, Congress passed the

Mortgage Forgiveness Debt Relief Act of 2007 (Debt Relief A ct).7 The

Debt Relief Act forgives the debt owed on a mortgag e and excludes the

forgiven debt from income under the tax cod e for homeowners who are

involved in a s hort sale, foreclos ure, or who want t o refinance to a

principal amount more reflective of the curren t market value.8

Specifically, the Debt Relief Act amended § 108 o f the t ax code, In come

from the Discharge of Indebt edness.9 It provides, “Gross inco me does not

include any amount which (but for thi s subsection) wou ld be includible in

gross i ncome by reason of discharge (in whole or in part) of indebtednes s

of the taxpayer if—the indebtedness discharged is qualifi ed principal

residence indebtedn ess which is discharged before Janu ary 1, 2010.”10

The exclu sions under § 108 were origi nally created b y the court s, and

later codified by Congress, to ensure that taxpayers trying to emerg e from

the financial distress of bankru ptcy and insolvency would actually get a

“fresh start.”11 In other words, those taxpayers who are in such financial

distress that they do not have assets sufficient to pay an immediate tax

liability should be granted some relief. Thus, assessing an immediate tax

bill ag ainst those t axpayers was dete rmined to be contrary to pub lic

policy.12 Rather, qualifying taxpayers are offered a tax deferral under §

108 allowing t hem to exclude the amount gai ned on discharge from the

current year, but requiring that other tax attributes be reduced so the tax is

“recaptured” in the future.13 The exclusions are meant to help t axpayers in

the worst financial condi tion get back to a point where their financial

situation is secure and they can afford to pay taxes.

6 Peter G. Gosselin, Bailout Is No Simple Matter, L.A. TIMES, Sept. 7, 2008, at A1.

7 Mortgage Forgiveness Debt Relief Act of 2007, Pub. L. No. 110-142, § 1, 121 Stat.

1803, 1803 (codified as amen ded in scattered sections of I.R.C.).

8 See Mortgage Forgiveness Deb t Relief Act, § 2, 121 Stat. at 1803–04.

9 I.R.C. § 108(a)(1)(E) (2006 ).

10 Id. There has already been an amendment extending the sunset date of the provision

to Jan. 1, 20 13. See Emergency E conomic Stabilization Act of 2008, Pub. L . No. 110-343,

§ 303(a), 122 Stat. 3765 , 3807 (codified as amended in scattered sections of 5, 12, 15, 31

U.S.C.).

11 See Adam M. Leamon, Note, Section 108 of the I.R.C . and Inclusion of Tufts Gain: A

Proposal for Reform, 50 B.C. L. REV. 1243, 1267–68 (2009).

12 Id.

13 Id. at 1266–67.

2010] MORTGAGE FORGI VENESS DEBT RELIEF ACT O F 2007 891

Adding an exclusion that applies to solvent homeowners who wish to

refinance th eir mortgage becau se money is a little short expands the

exclusions allowed u nder § 108 well beyond the o riginal poli cy goals of

helping bankrupts and ins olvents get a “fresh start.” In fact, when

codifying the exclusions, the Treasury Depa rtment expressed great concern

that solvent taxpayers would take advantage of the laws.14 For that reason,

Congress redrafted the language to specifically exclude solvent taxpay ers

from taking full advan tage of § 108.15

Part II of this article discuss es the hist ory of incl uding cancelled debt

as income and the exclusions created by the courts. Part III discusses the

Bankruptcy Tax Act of 19 80,16 which codified the judicial ex clusions, and

also discusses the policy reasons that justify th e exclusions. Part IV

discusses the real estate boom and su bsequent downturn that led t o the

exclusion for qu alified mortgage indebtedness. Part V compares the p olicy

considerations behind th e Bankruptcy Act of 198 0 and the Mortgage

Forgiveness Debt Rel ief Act of 2007.

II. THE IRS’S HISTORY OF TREATING DEBT CANCELL ATION AS

INCOME

A. Income as Defin ed by the IRS

The Internal Revenue Code defines gross income as any income “from

whatever source deri ved . . . .”17 “[T]he Court has gi ven a liberal

construction to this broad ph raseology i n recogniti on of the intention of

Congress to tax all gai ns except those specifically exempt ed.”18 Thus, th e

Court held t hat any accession to wealth, other than those specifically

14 See The Bankruptcy Tax Act and Minor Tax Bill: Hearing on H.R. 5043 Before the

Subcomm. on Select R evenue Measures of the H. Co mm. on Ways and Means, 96 th Cong. 9

(1979) [hereinaft er Bankruptcy Ta x Act Hearing] (statement of Daniel I. Ha lperin, Deputy

Assistant Secretary for Tax Po licy, Department of the Treasury).

15 S. REP. No. 96-1035, at 10 (1980), rep rinted in 1980 U.S.C.C.A.N. 7017, 7025.

16 Pub. L. No. 96-589, 9 4 Stat. 3389 (1980) (codified as amended in scattered sections

of 11, 26 U.S.C.).

17 I.R.C. § 61(a) (2006) (“Except as oth erwise provided in thi s subtitle, gross income

means all income from whateve r source derived, including (but not limi ted to) the following

items: . . . (12) Income from discharge of indebtedness . . . .” (emphasis added)). See also

United States v . Kirby Lumber Co. , 284 U.S. 1, 3 (1931); Comm’r v. Glenshaw Glass Co .,

348 U.S. 426, 43 0 (1955) (noting that this language first appear ed in the Revenue Act of

1913).

18 Glenshaw Glass Co., 348 U.S. at 4 30 (requiring a taxpayer to include in gross income

amounts gained through pun itive damages awarded in a civil trial).