The Mortgage Debt
Relief Act of 2007
by Tina Triano, Attorney

With foreclosures on the rise and many of my new clients seeking both tax and legal advice on this matter, it seems an appropriate time to discuss the realities of The Mortgage Debt Relief Act of 2007. Many taxpayers are of the opinion that they can just return their property to the lender and there will be no repercussions or taxes on the debt that is forgiven. In many cases, many of the clients I consult do not qualify for the debt relief as provided by the act.

Many real estate owners are surprised that if any of their real estate is foreclosed on, the tax law requires that the lender issue a 1099-C form, which reports the amount of the debt forgiven and the fair market value of the property at the time of the foreclosure. Taxpayers were then required to report this amount as income on their personal tax return. One way around this potential additional income tax was, and still is, to claim an insolvency exclusion. This is not the same as exclusion available under The Mortgage Debt Relief Act of 2007.

Under the IRS insolvency exclusion, if the total of your liabilities (what you owe) prior to the canceled debt, foreclosure or repossession exceeds the Fair Market Value of your assets (what you own), then you are not required to include the 1099-C income as taxable income on your personal tax return. This insolvency exclusion has been available to taxpayers for many years.

The Mortgage Debt Relief Act of 2007 merely creates a new exclusion that does not require insolvency when the debt forgiven involves a primary residence or what the IRS defines as “qualified principal residence indebtedness.” Note that the IRS uses the terms “principal residence” and “primary residence” interchangeably in their publications. The new law applies to mortgage debts that are renegotiated to a lower loan amount, short sales and foreclosures during tax years 2007 through 2012. It applies to loan amounts of $1,000,000 per person ($2,000,000 for a married couple).

The major caveat regarding this law is that the loan must be secured by your primary residence and must have been used to buy, build or “substantially improve” that residence. If you have refinanced your primary residence in the past few years and obtained cash out to consolidate credit cards, go on vacation or any other purpose other than to “substantially improve” your residence, the amount of the cash that you received is not excluded and will be subject to the tax unless you qualify for insolvency. The IRS can obtain these cash out records from your HUD-1 Final Closing Statement that you received at the time of the refinance. The burden of proof is upon you to prove the money was used for substantially improving your residence so make sure your records are in order.

This also means that all other property you own that is foreclosed upon cannot qualify for relief under this exclusion. It does not apply to second homes, rental properties, credit card debt, car loans, or any other debts. It must be your primary residence and only to the extent the loan amount was used for purchase, property improvements and/or building of the property.

If you have a second home, rental property or other real estate that is being or was foreclosed on, you may still avoid tax on the 1099-C income under the insolvency exclusion.

For more information regarding the Mortgage Forgiveness Debt Relief Act of 2007, visit www.irs.gov where you will find Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments along with a downloadable copy of tax form 982.

~Tina Triano Esq. is a California licensed attorney with over 15 years of trust and tax planning experience. Tina is available for group lectures and private consultations.