South Carolina Lawyer
SC Lawyer, November 2008, #4.
The Mortgage Forgiveness Debt Relief Act of 2007: Two New Provisions Regarding Principal Residences
South Carolina LawyerNovember 2008The Mortgage Forgiveness Debt Relief Act of 2007: Two New Provisions Regarding Principal ResidencesBy Kristin Balding GuttingIntroduction
In December of 2007, in response to the collapse of the housing market and the rapid increase in foreclosures, Congress enacted the Mortgage Forgiveness Debt Relief Act of 2007 (the "Act"). See Mortgage Forgiveness Act of 2007, Pub. L. No. 110-142, 121 Stat. 1803. Under the Act, Congress introduced several new provisions to the Internal Revenue Code (the "Code"), including two regarding an individual's principal residence. Mortgage Forgiveness Act of 2007 §§ 2 & 7 (codified in I.R.C §§ 108(a)(1)(E), 108(h), 121(b)(4)). The first-and the more highly publicized of the two-excludes the discharge of debt related to the acquisition and/or improvement of one's principal residence from ordinary income. See I.R.C. § 108(a)(1)(E), (h). The second modifies the exclusion of gain from the sale of the former marital principal residence by the surviving spouse. I.R.C. § 121(b)(4). This article provides an overview of the relevant laws regarding the discharge of indebtedness income and the exclusion of gain from the sale or exchange of a principal residence, with a focus on the changes to the law under the Act.
The qualified principal residence exclusion
For federal income tax purposes, when an individual borrows money, the borrowed funds do not constitute income to the individual. Although the borrower now has more money in his pocket, he also has an offsetting obligation to repay the debt. Therefore, the borrower does not have an accession to wealth. See Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 427-33 (1955). However, if the borrower is no longer required to satisfy such debt, then he has income, unless an exclusion exists. See I.R.C. § 61(a)(12).
There are several statutory exclusions for not including the discharge in ordinary income, including that the borrower is insolvent or the discharge occurs as part of a bankruptcy proceeding. I.R.C. § 108(a). Consequently, prior to the Act, when a lender foreclosed a mortgage and waived its right to seek any deficiency or if the value of the home declined and the lender forgave a portion of the borrower's mortgage, such amount of debt forgiveness constituted income to the borrower. I.R.C. § 61(a)(12). Thus, not only did an unfortunate person have to cope with the heartache of losing his home, but he also incurred a tax liability. This result was exacerbated by the fact that, for tax purposes, an individual cannot deduct the loss on the sale of a personal residence. I.R.C. § 165(a), (c). For example, in January of 2003, when the housing market was booming, Jackson purchased a home for $200,000 with an interest-only three-year adjustable rate mortgage from Bank X. In January of 2006, Jackson's payment substantially increased, as the interest rate increased, and he could no longer make his monthly payments. Accordingly, Bank X filed a foreclosure action against Jackson. Because of the decline in the housing market, the bank recovered only $175,000 at the foreclosure sale on Jackson's home. As a result, the proceeds from the foreclosure sale were inadequate to cover the balance on Jackson's note. Given Jackson's financial condition, Bank X forgave the remaining balance secured by the mortgage. In this example, Jackson had a loss on the sale of his house of $25,000. Concurrently, Jackson had ordinary income of $25,000, as the Bank forgave that amount and thus made him $25,000 wealthier. It would make sense that for tax purposes, Jackson should have been able to net his $25,000 loss and $25,000 of income. However, he could not deduct the loss and instead had $25,000 of discharge of indebtedness income.
Many people viewed this result as unfair, thus giving rise to the Act, which created "a three-year window for homeowners to refinance their mortgage and pay no taxes on any debt forgiveness they receive." Statement by President George W. Bush Upon Signing [H.R. 3648], 2007 U.S.C.C.A.N. S31, S32 (available at 2007 WL 4984167 (Dec. 20, 2007)). One of the main goals of the new provision was to "help hardworking Americans take steps to avoid foreclosure during a period of uncertainty in the housing market" by encouraging the modification of mortgages, including the forgiveness of part of the debt, without incurring a tax. Id. at S31.
Thus, pursuant to the Act, Congress added sections 108(a)(1)(E) and (h), which provide that the cancellation of "Qualified Principal Residence Indebtedness" (QPRI) is not income. QPRI is debt not exceeding $2 million (or $1 million if married filing separately) related to acquiring, constructing or substantially improving an individual's principal residence. I.R.C. § 108(h)(2). QPRI also includes the refinancing of mortgages in amounts not exceeding the old mortgage principal immediately before the refinancing. I.R.C...