Special Rules Enacted to Address Sub-Prime and Other Problems

Special Rules Enacted to Address Sub-Prime and Other Problems

By: Martin M. Shenkman, CPA, MBA, JD

Cancellation of Homeowners’ Debt Special Rules The discharge of home mortgage debt generally will result in your client realizing taxable income. The 2007 Mortgage Forgiveness Debt Relief Act enables homeowners to avoid this tax cost during 2007–2009 by excluding the amount of debt forgiven from gross income. IRC Sec. 108(a)(1)(E); See IR 2008-17. This new law is a great tax break for clients with home values below their mortgages, but it is complicated and has a number of traps. A summary of many of the rules and planning considerations follows:

  • Your client can restructure “acquisition debt” (see the definition above concerning qualification for home mortgage interest deductions) on a principal residence, or a principal residence is lost in a foreclosure. Vacation and second homes do not qualify.
Pointer: Client’s who have second homes in lower tax states and have argued that they are residents there (e.g. Florida) for tax purposes probably cannot claim their other home (e.g., New Jersey) as “principal”. The client’s accountant can confirm how income taxes were filed for these purposes.
  • Only “acquisition debt” qualifies for this benefit. This is defined as debt on a principal residence incurred to acquire, construct, or substantially improve the principal residence that is secured by the residence (i.e., the lender has a mortgage). If your client refinanced, only debt up to the amount of debt you refinanced is included. Section 163(h)(3)(B). Caution: If your client refinanced a $200,000 mortgage for $300,000 and used the additional funds for college, vacations, etc. (anything but permanent home improvements), that extra $100,000 won’t qualify for mortgage relief (unless it qualified as the client’s home equity line allowance) so your client will realize taxable income if it is forgiven.
  • The loss is directly related to a decline in the value of the house or to your client’s financial condition. IRC Sec. 108(h)(3).
  • The client is not in a Title 11 bankruptcy (if the client is bankrupt, then the bankruptcy rules apply instead. See IRC Sec. 108(a)(2)(A)).
  • If your client is insolvent this rule won’t apply if your client chooses (“elects”) not to have it apply. The client can instead use the special rules for insolvent taxpayers. IRC Sec. 108(a)(1)(B).
  • Pointer: The tax benefit for an insolvent taxpayer is limited to the amount of insolvency before the client’s home was foreclosed. The special home mortgage forgiveness rule recently enacted is not subject to that limitation.
  • No more than $2 million of debt will qualify ($1 million for married taxpayers filing separate tax returns). IRC Sec. 108(h)(2).
  • Your client will receive Form 1099-C from the lender informing him or her as to how much debt was forgiven. Your client will report this amount on their tax return.
Practice Pointer: This tax form does not provide all of the information the client needs to address all the issues involved.
  • The client should report the amount of debt forgiven on Form 982, and file it with their Form 1040 individual income tax return.
Pointer: Consider state income tax consequences.
  • This new debt forgiveness rule doesn’t prevent your client from recognizing gain if the fair value of the home exceeds what you paid for it.
Example: Tina Smith has a $250,000 loan secured by a mortgage on the house. Smith paid $220,000 for the home (her tax basis). Smith’s lender foreclosed on the loan in 2008 when the house was worth $240,000. The foreclosure results in two types of income: 1) Debt discharge income of $10,000 ($250,000 mortgage less $240,000 home value). This $10,000 of debt discharge income is excluded from Smith’s income under this new debt forgiveness rule; and 2) Taxable gain of $20,000 ($240,000 home value minus $220,000 cost). The $20,000 gain must be recognized as income, unless it qualifies for the home sale exclusion rules. IRC Sec. 121. Different rules apply if the homeowner was not personally liable on the loan. See generally IRS Publication 4681. Repossession and Re-Sale of Home Another related rule might also help homeowners facing financial adversity with respect to their homes. If your client’s home is repossessed and later sold, the client will not have to report gain or loss on the repossession. Instead, the client’s gain will all be treated as part of the original sale of the house. IRC Sec. 1038(e). This rule must be applied if: (1) your client excluded some of the gain on the sale of the home under the general home sale exclusion rules (the $250,000 for a single person/$500,000 for a married couple) under IRC Sec. 121, and (2) the repossessed home is resold within one year. This special rule might help your client qualify any gain on the later sale of the repossessed home for the home sale exclusion and thus avoid any taxable gain.   DISASTER RELIEF AND CASUALTY LOSSES OF PERSONAL RESIDENCE If your client's home is damaged by a disaster in an area declared by the President as a designated disaster area, special tax benefits may be available. IRC Sec. 1033(h). There are a host of technical, detailed and often limited benefits enacted when major disasters occur. Therefore, any discussion below should be viewed only as illustrative, not authoritative.
  • Taxpayers generally don't have to recognize a gain for tax purposes on their receipt of insurance proceeds for personal property that comprised the contents of their house. Rev. Rul. 95-22. This favorable rule applies regardless of your client's tax basis in the personal property. It also won't matter how your client applies the insurance proceeds they receive.
  • Your client can treat insurance proceeds received for the damage to their house or its contents as a single fund for tax purposes. The client can choose (elect) to recognize gain only to the extent the aggregate insurance funds exceeds the cost of replacing the home and its contents.
  • Taxpayers are given four years after the year the gain is realized (i.e., the year they receive the insurance proceeds) to reinvest. This is favorable, in that it exceeds the two-years generally allowed for when your client has an involuntary conversion and replacement.
  • The Katrina Emergency Tax Relief Act of 2005 (KETRA) extends the normal replacement period for involuntary conversion gains to five years for property (whether business or non-business property, such as a home) that was destroyed (involuntarily converted) by Hurricane Katrina.
  • Money received as a qualified disaster relief payment is excluded from gross income. IRC Sec. 139. This could include payments received to repair, rehabilitate, or replace a personal residence, or your furniture and other home contents. A qualified disaster includes damage from a terrorist or military action, a presidentially declared disaster (IRC Sec. 1033(h)(3)), a disaster resulting from an accident involving a common carrier, or from any other tragedy that the IRS determines to be catastrophic in nature.
  • If your client's home is destroyed, seized by a government authority, or condemned, the proceeds will be treated as if received in a qualifying sale of your principal residence. This can enable your client to qualify the proceeds for the $250,000 ($500,000 if married filing a joint return). IRC Sec. 121(d)(5)(A). When your client applies these rules, they first reduce the amount of gain by money they were able to exclude because of the casualty, condemnation, etc.
  • If your client's home is destroyed in a casualty, and their tax basis is determined using the special tax rules that apply to involuntary conversions (Code Sec. 1033), the holding and use of the converted property (e.g., a replacement home) is treated as the holding and use of the destroyed house.
  • Your client can elect to deduct a loss realized because of a disaster in a Presidentially declared disaster area on their tax return for the year prior to their actual loss. More specifically, this benefit applies to an area the President decides qualifies for assistance under the Robert T. Stafford Disaster Relief and Emergency Assistance Act. IRC Sec. 165(i).
  • For your client to defer all of the gain on the proceeds they receive because of a disaster, they need to purchase a replacement home (technically, property that is similar or related in service to the property destroyed) that costs as much as the insurance and other proceeds received.
  • To qualify for these favorable tax benefits under Code Section 1033 the property involved must have been so damaged that it cannot be repaired. Your client doesn't have to actually invest all of the insurance or other proceeds in the replacement home. They can still obtain a mortgage for the new home. The key is that the total cost of the replacement property exceed the funds received, not that they actually put the same dollars into the new home. IRC Sec. 1033(a)(2); Treas. Reg. 1.1033(a)-2.

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