IRS Provides Guidance on Mortgage Modifications
February 4, 2013
We came across this very detailed article regarding loan modifications and the IRS. Michael Cohn does a great job explaining what can be a difficult topic!
IRS Provides Guidance on Mortgage Modifications
Washington, D.C. (January 24, 2013)
By Michael Cohn
The Internal Revenue Service is offering guidance on mortgage principal reductions in the federal government’s program for mortgage modifications for borrowers who have fallen behind on their payments.
The guidance in Revenue Procedure 2013-16 aims to help borrowers, mortgage loan holders and loan servicers who are participating in the Principal Reduction Alternative offered through the Treasury Department’s and Department of Housing and Urban Development’s Home Affordable Modification Program, also known as HAMP-PRA.
To help financially distressed homeowners lower their monthly mortgage payments, the Treasury Department and HUD established HAMP, which is described at http://www.makinghomeaffordable.gov/. Under HAMP-PRA, the principal of the borrower’s mortgage may be reduced by a predetermined amount called the PRA Forbearance Amount if the borrower satisfies certain conditions during a trial period. The principal reduction occurs over three years.
Under the program, if the loan is in good standing on the first, second and third annual anniversaries of the effective date of the trial period, the loan servicer reduces the unpaid principal balance of the loan by one-third of the initial PRA Forbearance Amount on each anniversary date.
This means that if the borrower continues to make timely payments on the loan for three years, the entire PRA Forbearance Amount is forgiven. To encourage mortgage loan holders to participate in HAMP–PRA, the HAMP program administrator will make an incentive payment to the loan holder, known as a PRA investor incentive payment, for each of the three years in which the loan principal balance is reduced.
The guidance issued Thursday by the IRS provides that PRA investor incentive payments made by the HAMP program administrator to mortgage loan holders are treated as payments on the mortgage loans by the United States government on behalf of the borrowers. These payments are generally not taxable to the borrowers under the general welfare doctrine.
If the principal amount of a mortgage loan is reduced by an amount that exceeds the total amount of the PRA investor incentive payments made to the mortgage loan holder, the borrower may be required to include the excess amount in gross income as income from the discharge of indebtedness. However, many borrowers will qualify for an exclusion from gross income.
For example, a borrower may be eligible to exclude the discharge of indebtedness income from gross income if (1) the discharge of indebtedness occurs (in other words, the loan is modified) before Jan. 1, 2014, and the mortgage loan is qualified principal residence indebtedness, or (2) the discharge of indebtedness occurs when the borrower is insolvent. For additional exclusions that may apply, see Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals).
Borrowers receiving aid under the HAMP–PRA program may report any discharge of indebtedness income—whether it is included in, or excluded from, gross income—either in the year of the permanent modification of the mortgage loan or ratably over the three years in which the mortgage loan principle is reduced on the servicer’s books. Borrowers who exclude the discharge of indebtedness income must report both the amount of the income and any resulting reduction in basis or tax attributes on Form 982 Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).
The guidance issued Thursday explains that mortgage loan holders are required to file a Form 1099-C with respect to a borrower who realizes discharge of indebtedness income of $600 or more for the year in which the permanent modification of the mortgage loan occurs. This rule applies regardless of when the borrower chooses to report the income (that is, in the year of the permanent modification or one-third each year as the mortgage loan principal is reduced) and regardless of whether the borrower excludes some or all of the amount from gross income.
Penalty relief is provided for mortgage loan holders that fail to file and furnish the required Forms 1099-C on a timely basis, as long as certain requirements described in the guidance are satisfied.
Foreclosed? The tax man may want his cut
April 18, 2011
If so, you could be facing a big tax hit.
It is IRS policy to tax forgiven debt you are personally responsible for as if it is income. Say, for example, your credit card company settled a $10,000 debt for 50 cents on the dollar. You’d have a debt forgiveness of $5,000, which the IRS would count just like your wages.
The same policy held true for most mortgage debt until 2007, when Congress passed the Mortgage Forgiveness Debt Relief Act. That ended the liability for many homeowners — but not all.
In general, if you lose your home to foreclosure or short sale, where you sell your home for less than you owe, the IRS won’t add insult to injury by counting the difference as income, at least until 2012, when the act expires.
There are four major exceptions to the rule:
1. You did a cash-out refinance and splurged.
Many homeowners took cash out when they refinanced their homes and used the extra dough to pay for new cars, boats, vacations or other spending.
Say you did that and then got into trouble, losing the house through a foreclosure or short sale. Even if your lender waived the remaining debt, the IRS will treat as income the portion of the forgiven debt that you took out as cash and spent.
Only the funds used to actually improve your home won’t be taxed (plus the costs of refinancing the loan). Yes, even if you spent the money on paying off your student loans or credit cards.
The IRS’ reasoning is that only the money spent on home improvement actually added to your home’s value. And that, presumably, diminished the difference between what you owed on your mortgage and the value of your home when it was foreclosed.
Beware: Some lenders made refinancing offers contingent on homeowners paying off credit card debt, according to Kent Anderson, a Eugene, Ore.-based attorney and tax expert. If you took one of those deals, the refinance money will be reported to the IRS and you will owe taxes on it.
2. You have a home-equity line of credit.
The same rules that apply to refinancings also apply to home-equity loans: The IRS will only forgive the tax liability if the loan money was spent on home improvements. And, tax experts advise, be prepared to show receipts to prove it.
3. You lost your vacation home or investment property.
So the market tanked and you lost your vacation home. Unfortunately, if you didn’t use it as your primary residence for at least two of the previous five years, you’re going to pay the tax man.
More common, however, may be the case of investment properties gone sour. During the housing boom, buying homes for investment purposes soared, accounting for 28% of all sales during 2005, according to the National Association of Realtors. (Vacation homes made up 12%.) And many of these purchases were made with little down payment.
When the bust hit, second home prices cratered. The median price for investment properties fell nearly in half to $94,000 by 2010, according to NAR. For vacation homes, the median price paid dropped 26% to $150,000.
If an investor bought a property in 2005 at the median price and sold it in 2010, she could have run up almost $90,000 in forgiven debt. If she’s in the 25% tax bracket, that would add more than $22,000 to her tax liability. Ouch!
4. You owned a multi-million-dollar home.
It may be hard for Americans struggling in this weak economy to sympathize with anyone wealthy enough, at one time, to afford a multi-million-dollar home, but owners losing one could be on the hook for a huge tax bill.
Only the first $2 million in forgiven debt will be voided under the relief act; all the overage is taxable as income.
So, say, for example, you’re ex-ballpayer and self-styled stock-picker Lenny Dykstra and paid $18.5 million to Wayne Gretzky for a mansion in Thousand Oaks, Calif. When you defaulted on the loan in 2009 and the house was auctioned in 2010 for $10.5 million, you could be on the hook for $6.5 million of the $8.5 million in forgiven debt.
Other ways out
The good news? Even if you fall under any of these four scenarios, you may have a way out, according to Anderson. “If the taxpayer was insolvent at the time of the foreclosure, the forgiven debt can be excluded for tax purposes,” he said. “It can also be discharged in a bankruptcy and approved by court order.”
People like Dykstra could elude taxes because California is a “non-recourse” state. Lenders there accept homes as the collateral for the debt and when a bank forecloses, the loan is regarded as paid in full. Since there’s no debt to forgive there’s no taxable income.
It’s not always that simple, though. Many homeowners in California and other non-recourse states have refinanced their mortgages and refis are, as a rule, recourse loans, according to attorney Bill Purdy in Santa Cruz,. “A refi destroys your non-recourse status,” he said. If a big debt is forgiven, borrowers may owe taxes.
Purdy also explained that banks often file 1099 forms with the IRS that mistakenly list debt forgiveness when there was none.
“People need to regard the 1099s with suspicion,” he said. “I’ve had clients in here who have been making payments to the IRS when they had non-recourse loans.”
As long as the Mortgage Forgiveness Debt Relief Act stays in effect, only borrowers for the most expensive properties in foreclosure will have to worry. After that, though, it may pay for any homeowner in foreclosure to be very aware of their tax exposure — and plan accordingly.”
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