The Mortgage Debt Forgiveness Act of 2007

As the subprime mortgage crisis has escalated, struggling homeowners have been hit with a double whammy: loss of their homes to foreclosure followed by an unexpected tax bill.

But thanks to a new law, some homeowners now will see their tax liability in these cases eliminated.

The Mortgage Debt Forgiveness Act of 2007 covers what many unsuspecting homeowners saw as punishment of the homeowner for a lender's seemingly benevolent move -- the writing off, or forgiveness, of some of a mortgage loan.

Under prior law, when a home's value decreased and the lender and borrower negotiated a reduction in loan principal, the difference between the original and new debt was taxable income. A homeowner also could face similar tax liability when the lender completed a foreclosure and sold the home for less than the outstanding mortgage.

Officially, it is known as cancellation of debt, or COD income. It also is sometimes called discharge of indebtedness income or debt forgiveness. Regardless of the name, it produced a homeowner tax bill, generally calculated at ordinary rates ranging from 10 percent to 35 percent depending upon the homeowner's income.

"What the (previous) tax law essentially did was treat the foreclosure as a sale by the debtor, the owner of the property, with the proceeds being paid to the lender," says Frederick M. Stein, RIA senior analyst from Thomson Tax & Accounting.

Now, however, some homeowners who renegotiate their mortgages within a three-year window -- the law applies to transactions retroactively from Jan. 1, 2007, through Dec. 31, 2009 -- will not face any taxes on debt forgiven in the process.

In signing the measure into law, President Bush lauded the benefits of the temporary tax abatement.

"When you're worried about making your payments, higher taxes are the last thing you need to worry about," said Bush. "So this bill will create a three-year window for homeowners to refinance their mortgage and pay no taxes on any debt forgiveness that they receive. ... The provision will increase the incentive for borrowers and lenders to work together to refinance loans and it will allow American families to secure lower mortgage payments without facing higher taxes."

Still some restrictions
Although mortgage-related COD income is off the tax books for the next three years, some homeowners facing financial difficulty could still end up facing an IRS bill.

There is a $2 million limit on the amount of COD income that escapes taxation.

The loan must be to buy, build or substantially improve a principal residence, i.e., the property in which the homeowner lives. Debt forgiven on vacation or investment properties or a second home will still count as income.

And homeowners who took advantage of the run-up in real estate prices to refinance their mortgages can only use the new law in connection with higher mortgage debt that was used to improve the home. Such cash-out refinancings where the homeowner took out money to pay for purchases, such as a vehicle or to pay off credit card debt, don't qualify for the exclusion if they are forgiven.

Mark Luscombe, principal federal tax analyst with CCH, a tax software and publishing company in Riverwoods, Ill., says that taxpayers who take advantage of the new law will have to reduce their basis in their homes by the amount excluded. For example, someone who paid $300,000 for a house and had $20,000 in mortgage debt forgiven will figure that their basis in their home is now $280,000. If they later sell their home for $350,000, their gain will be $70,000 rather than $50,000.

The good news here is that other home-related tax law offers some cover. "Since single people can exclude as much as $250,000 in gain on the sale of a home, and joint filers as much as $500,000, in many cases there is no tax due anyway," says Luscombe. "Even if there is, most people would be willing to trade a capital gains tax in the future for tax relief at ordinary income rates today."