Taxes Could Apply to FHA Short Refi Principal Reduction

“It was as true as taxes is.  And nothing’s truer than them”.

-Charles Dickens

Recently we’ve talked a lot about loan modification programs such as Home Affordable Modification Program (HAMP), Home Affordable Refinance Program (HARP), and the new FHA short refinance program.  We have discussed many of the pitfalls and issues that plague these programs, as well as the benefits that apply to those that manage to qualify for them.  One thing we have not really talked about is the potential tax liability these programs can cause.

Any type of loan forgiveness (principal reduction) can be considered a debt discharge income (DDI) by the IRS.  As such, loan forgiveness may be taxable.  Any time a lender forgives more than $600, they may send a 1099-c form to you and the IRS, and you may be required to report the forgiven loan amount as income.  Some lenders report the forgiveness to the IRS, others do not.  Many things affect whether or not DDI is taxable or not, such as your solvency at the time the debt was forgiven.

In 2007, Congress passed the Mortgage Debt Relief Act, which allows borrowers to exclude some debt discharge income on their principal residence.  The act currently applies to many mortgage write-downs that occur or occurred between 2007-2012.  I am not a tax attorney, so nothing that I write here is meant to be construed as legal advice.  It is extremely important to consult an attorney when undergoing any sort of mortgage modification program, because you do not want to end up with a surprise bill at tax time.

The following is an excerpt of the FAQ from the Mortgage Forgiveness Act page of IRS.gov.  I recommend clicking through and reading the whole thing for further information.

Is Cancellation of Debt income always taxable?
Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:

  • Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
  • Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
  • Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
  • Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.
  • Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.

What is the Mortgage Forgiveness Debt Relief Act of 2007?
The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007 (see News Release IR-2008-17). Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence.

What does exclusion of income mean?

Normally, debt that is forgiven or cancelled by a lender must be included as income on your tax return and is taxable. But the Mortgage Forgiveness Debt Relief Act allows you to exclude certain cancelled debt on your principal residence from income. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

Does the Mortgage Forgiveness Debt Relief Act apply to all forgiven or cancelled debts?

No. The Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. This is known as qualified principal residence indebtedness. The maximum amount you can treat as qualified principal residence indebtedness is $2 million or $1 million if married filing
separately.

Does the Mortgage Forgiveness Debt Relief Act apply to debt incurred to refinance a home?

Debt used to refinance your home qualifies for this exclusion, but only to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified. For more information, including an example, see Publication 4681.
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