The Mortgage Forgiveness Debt Relief Act of 2007 was signed into law by President Bush on December 20, 2007. The purpose of the Act is primarily to exclude “discharges of indebtedness” on qualified principal residences from one’s gross income. Generally, a “qualified principal residence” is a home where the individual resided for two out of the past five years.
The Act creates a three-year window for homeowners to refinance, or receive debt forgiveness on their home loan while paying no taxes on any forgiven debt that they receive. The Act applies to discharges of indebtedness that occur on or after January 1, 2007 and before January 1, 2010. Under the previous law, if the value of one’s home declined, and their bank or lender forgave a portion of their home loan, the tax code treated the amount forgiven as income that could be taxed.
Let’s look at the following example… John Smith bought a $250,000 home in 2004, taking out a $200,000 loan in the form of a 3-year ARM. By the end of 2007 the value of his home dropped to $175,000, and his interest rate adjusted upward thereby causing his monthly home loan payments to skyrocket. After having lived in his principal residence for three out of the past five years, recognizing that he could no longer afford to make his payments, and realizing that he is inhibited from refinancing, Mr. Smith is faced with some options; two of the most feasible options being (a) sell the home by way of a “short-sale,” or (b) allow the lender to foreclose.
Regardless of which option Mr. Smith selects, he is likely to realize forgiven debt; that forgiven debt being the difference in what he owes (i.e. ~$200,000) and what the lender collects from either the short-sale or Trustee’s sale (i.e. foreclosure sale). Given that Mr. Smith lived in his home for two out of the past five years, it likely constitutes a qualified principal residence for purposes of the Act. As such, any debt forgiveness realized by Mr. Smith (as evidenced by IRS Form 1099), will not treated as “income” for purposes of determining his annual gross income for the respective tax year.
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