Solidifying the Exclusion for Cancellation of Indebtedness Income Related to Home Loan Reductions: a Petition to Make Permanent Irc Section 108(a)(1)(e), ,

• Publication year: 2023
• Author: Saba S. Shatara

SOLIDIFYING THE EXCLUSION FOR CANCELLATION OF INDEBTEDNESS INCOME RELATED TO HOME LOAN REDUCTIONS: A PETITION TO MAKE PERMANENT IRC SECTION 108(A)(1)(E)1 , 2 , 3

AUTHOR

Saba S. Shatara

Michael Day

EXECUTIVE SUMMARY

In 2009, foreclosure threatened millions of American homeowners in what was the biggest housing crisis since the Great Depression. Although the climate of bankruptcies and mortgage foreclosures improved during much of the following decade, the current COVID-19 pandemic has thrust many homeowners back into a state of financial uncertainty. Despite mortgage relief programs, such as foreclosure moratoriums, designed to protect homeowners during such unprecedented times, the fears of bankruptcy and foreclosure still loom for many Americans. Preventing the recognition of discharged debt as income through section 108 of the Internal Revenue Code⁴ is one particularly effective avenue for addressing the issues of bankruptcy and foreclosure. Specifically, section 108(a)(1)(E), created through the Mortgage Forgiveness Debt Relief Act of 2007 and the Emergency Economic Stabilization Act of 2008 and discussed in greater detail below, allows taxpayers to exclude from taxable income cancellation of "qualified principal residence indebtedness" through January 1, 2026.⁵

Although section 108(a)(1)(E) was initially authorized to last until January 1, 2010, the United States Congress ("Congress") has repeatedly extended 108(a)(1)(E) due to its recognition of the lasting effect of the mortgage crisis and the fact that taxpayers with mortgages higher than the value of their home—i.e., homes with "negative equity"—still require relief from the potential CODI when forced to restructure mortgage debts or when facing home foreclosure. Congress has voted to extend the applicability of Section 108(a)(1)(E) each time the provision is set to expire.

Accordingly, as explained in greater detail below, this proposal recommends that Congress consider making section 108(a)(1)(E) a permanent provision. This proposal recognizes that section 108(a)(1)(E) is a crucial tool that may help protect taxpayers who are facing potential foreclosure and, as noted in Babin v. Commissioner, "is premised on the belief that it is inequitable 'to kick someone when he is down.'"⁶ Finally, this proposal will attempt to demonstrate how making section 108(a)(1) (E) permanent is consistent with the policies inherent to section 108's exceptions, as well as the general policy considerations contained in the code.

DISCUSSION

INTRODUCTION

As noted above, this proposal recommends that Congress consider making Section 108(a)(1)(E) a permanent provision. This proposal will first explore the background and rationale for cancellation of indebtedness income ("CODI"), as well as the history of Section 108(a)(1). Next, the proposal will demonstrate the need to make Section 108(a)(1)(E) permanent, noting that: (1) the housing market conditions indicate an immediate and future need for Section 108(a)(1)(E); (2) COVID-19 has increased the need for relief for American mortgage holders; (3) making Section 108(a)(1)(E) permanent is consistent with and furthers already existing policies established by Section 108 generally

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as well as the provisions of the IRC that encourage home ownership; and (4) the need for constant renewal poses a danger to taxpayers. This proposal will also discuss potential challenges to enacting Section 108(a)(1)(E) permanently.

BACKGROUND OF CODI AND SECTION IRC SECTION 108

THE TAX TREATMENT OF LOANS AND CANCELLATION OF DEBT INCOME GENERALLY

As a preliminary matter, Section 61 of the IRC requires individuals to recognize all income from whatever source derived, including income from discharge of indebtedness.⁷ This principle comes from the idea that gross income is based on the presence of some accession to wealth or economic benefit to the taxpayer.⁸ In keeping with this tenet of tax law, taxpayers do not generally recognize the proceeds from a loan as income.⁹ Instead, gross income excludes borrowed funds because the obligation to repay the loan offsets the accession of wealth despite the fact that the taxpayer immediately increases his or her assets and can use the loan amount without restriction.¹⁰ Thus, analyzing a borrowing transaction in its totality, the wealth of taxpayers who take loans to purchase their homes is not increased when the taxpayer takes the loan because these taxpayers have a corresponding obligation to repay said loan. Additionally, the taxpayer may not deduct its principal payments from income,¹¹ which means the repayment of such a loan has no effect on the taxpayer's tax liability.

With respect to funds borrowed by taxpayers for the purpose of purchasing property, and specifically in the context of home loans for principal residences, the taxpayer's basis in the property is generally equal to the full purchase price, which includes within it any loan amounts used towards the purchase.¹² Full ownership requires repayment of the loan and therefore the full loan amount is included as the cost of the property.¹³ On the sale of the property, the borrower's gain is calculated as the sales proceeds minus the basis as defined above.¹⁴ Therefore, because taking a loan does not result in a realization event¹⁵ and property bought with borrowed funds takes a basis equal to "the full value of the consideration provided," debtors must face the tax consequences after discharging a portion of their debt obligation for less than full payment.¹⁶ , ¹⁷ These consequences arise under Section 61(a)(12), which holds that if debt owed is renegotiated or a portion is otherwise canceled for less than its original amount, the taxpayer generally must recognize gross income equal to the amount of debt canceled.¹⁸

While the general rule holds that canceled debt is recognizable income,¹⁹ Section 108 lists a number of exceptions that allow taxpayers to prevent recognition of income derived from this discharge of indebtedness.²⁰

IRC SECTION 108(A)(1)(E): BACKGROUND AND CURRENT PERMUTATION

Section 108(a)(1)(E) emerged primarily as a result of the sub-prime mortgage loan crisis in the mid to late 2000's.²¹ Congress was concerned that taxpayers forced to restructure mortgage debts or facing home foreclosures would also recognize income from the cancellation of indebtedness.²² Thus, through the Mortgage Forgiveness Debt Relief Act of 2007 (which was amended by the Emergency Economic Stabilization Act of 2008), Congress created 108(a)(1)(E), which originally excluded from gross income the cancellation of "qualified principal residence indebtedness" if the cancellation occurred on or after January 1, 2007 and before January 1, 2010.²³ For these purposes, "qualified principal residence indebtedness" was limited to acquisition indebtedness—indebtedness incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, secured by such residence²⁴ —considered with respect to a taxpayer's principal residence²⁵ and not exceeding $1,000,000.²⁶

Although Section 108(a)(1)(E) was a new provision at the time it was enacted, the concepts underlying it were not. Instead, Section 108(a)(1)(E) was created upon a preexisting framework of beneficial tax rules regarding principal residences constructed by Section 121.²⁷ Moreover, Section 108(a)(1)(E) does not apply to indebtedness on a home that is not the taxpayer's principal residence, nor does it apply to home equity indebtedness.²⁸ Indeed, this provision applies only if the debt cancellation is due to a decline in (1) the value of the home, or (2) the taxpayer's financial condition.²⁹ When a taxpayer uses the section 108(a)(1)(E) exclusion, instead of recognizing the CODI in the year of the event, the basis in the qualifying property is reduced by the excluded amount.³⁰

Since its inception in 2007, Section 108(a)(1)(E) has been renewed and extended eight times—in 2008, 2010, 2013, 2014, 2015, 2018, 2019, and 2020.³¹ Each time, these extensions served to protect taxpayers from recognizing CODI when seeking out a loan modification. The current permutation of Section 108(a)(1)(E) is provided in pertinent part below:

(1) In general. Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—

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(E) the indebtedness discharged is qualified principal residence indebtedness which is discharged—

(i) before January 1, 2026, or
(ii) subject to an arrangement that is entered into and evidenced in writing before January 1, 2026.

As provided, the law extends this taxpayer protection through the end of 2025, unless further extended.

THE PROBLEM AND PROPOSAL: MAKE IRC SECTION 108(A)(1)(E) PERMANENT

This proposal recommends that Congress consider making IRC Section 108(a)(1)(E) a permanent provision by removing the expiration date contained in subparagraphs (i) and (ii). Such an action seeks to address one simple problem: taxpayers with mortgages higher than the value of their home—i.e., homes with "negative equity"—still require relief from the potential CODI if they restructure mortgage debts or are facing home foreclosure. Making this provision permanent would acknowledge that, like other provisions in Section 108 (e.g., those addressing bankruptcy and insolvency), those facing the threat of losing their home warrants protection from an additional, and potentially crippling, tax burden. Further, allowing this provision provides an alternative to those taxpayers who would not otherwise qualify under the insolvency exemption for CODI or who are unable or do not wish to use the bankruptcy exemption.

RATIONALE FOR MAKING SECTION 108(A)(1)(E) PERMANENT

As discussed in further detail below, we recommend Congress consider making Section 108(a)(1)(E) a permanent provision because doing so: (1) fulfills the current needs of taxpayers engaged in the housing and...