Expiration of the Mortgage Forgiveness Debt Relief Act

December 3rd, 2013 by attorney Chris Hacker

Now that the shutdown has passed, and the next ‘fiscal cliff’ is still a little ways away, the Mortgage Forgiveness Debt Relief Act of 2007 is back in the news. The Act is once again set to expire at the end of this year, after being extended last year. And once again, people are starting to make a really big deal about its expiration.

As I explained last year, it’s all a waste of breath. It doesn’t really matter if it expires.

People are lining up predicting both its extension and its demise. On the demise side, there is the $1.3 Billion/year in uncollected revenues, as projected by the Congressional Budget Office. On the extension side, people point to the $1.3 Billion/year tax ‘increase’ of not extending it and claim that it will destroy the short sale market and borrower participation.

(Here’s a short (less than 2 min) video describing the reality of the expiration of the Mortgage Forgiveness Debt Relief Act. Let us know if you think it helps make things clearer, and if it’s helpful to your sellers and owners facing foreclosure or pursuing a short sale.)

Details of Mortgage Forgiveness Debt Relief Act

Once again, this is a situation of some pundits having just enough information to be dangerous. The reality is it doesn’t really matter if the law expires, as far as the macro market goes. If you have a financial hardship, you will likely not pay taxes anyway. The Mortgage Forgiveness Debt Relief Act altered the IRS tax code adding an additional exception for owner occupied properties where the forgiven debt was used for the purchase or substantial improvement of that property, up to a limit of $1M if you are single and $2M if married. The key word there is additional.

When Congress passed the Mortgage Forgiveness Debt Relief Act, the IRS code already provided forgiven debt tax forgiveness for insolvency, with no upper limit or other restriction. If you had debt of any kind forgiven and you were insolvent at the time it was forgiven, then you did not have to pay taxes as long as you filled out the IRS tax form. And just for clarity, insolvency is a simple concept for the IRS code: if you owe more than you have, you are insolvent. So if you have $20,000 in savings and stocks along side a $300,000 mortgage on a house worth $225,000, then your net worth is at most $300k-$245k = -$55k. That means you are insolvent. Most people who are doing a short sale are insolvent. That’s why they are doing the short sale.

One other item to note. For those who think people will refuse to short sell because of the expiration of the Act, the correct question back to them is this: what’s their other option? Foreclosure? If they are foreclosed on or do a deed-in-lieu of foreclosure, the same tax issue exists because the bank is forgiving recourse debt. Unless the bank chooses to get a judgment and pursue that judgment, then they are going to forgive the debt so they can take the write off. They take the write off, they issue a 1099C to the former borrower, and that borrower now has income to pay taxes on. People who are considering a short sale are not deciding whether to keep the house or do a short sale as a rule. It’s not a stay or go situation. They are moving out. The only question is, how and on what terms?

So you might ask, what’s the deal with the noise about the expiration of the Mortgage Forgiveness Debt Relief Act? Well, politicians do not like to be seen doing nothing. So, it’s partially political theater. Also, the people who will have $1 – 2M in debt forgiven also are likely to have a fair amount of access to their political representatives, and politicians don’t like to be seen not taking action, especially to people who have access to them. Beyond that, the noise seems mostly to do with a lack of understanding of the IRS tax code, surprise surprise.

So, what does that mean at the end of the day for short sales and taxes? Well, short sales will continue to take place whether or not the Act is extended, because the vast majority of people doing them don’t have a choice to keep the property. Most people who sell via short sale will have no tax implications provided they complete the proper form to file with their taxes.

What Others Think

When I talk with people about this, the response generally ranges from relief to outright challenge. And people usually have a number of responses:

  • Where can I look to see the language for the insolvency exception? (I’ll show you just below)
  • What do you mean it doesn’t matter for most? Why is everyone saying otherwise?
  • But my/my client’s accountant/attorney said….

A typical response follows the email I received via email from one of our users last year at this time. (I’ve edited out the details about the transaction for privacy purposes.)

We are racing against the clock trying to get approval (which appears likely) for our short sale and close by Dec. 31st because my seller feels certain she will have to pay a huge tax liability on the deficiency. She says her accountant told her she would but this article seems to be indicating the possibility she might not??? …. We are very, very close to getting this accepted except for the time factor. My seller refuses to move forward after Dec. 31st for fear she will owe a tremendous tax debt. Any help you can suggest is GREATLY appreciated!

Another person once pointed out that the Wikipedia entry for the Mortgage Forgiveness Debt Relief Act did not agree with what I’ve written, and asked what I had to say about that.

Well, here it is: anyone that says that there will be NO tax relief for any distressed homeowners if/when the Mortgage Forgiveness Debt Relief Act expires, IS FLAT WRONG.

Prove it? Sure.

  • irs publication 4681

    IRS Publication 4681, page 4, 3rd column

  • Here’s the relevant text:

    “Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation….

    Note. This exclusion does not apply …. if the debt is qualified principal residence indebtedness …. unless you elect to apply the insolvency exclusion instead of the qualified principal residence indebtedness exclusion.” (emphasis mine)

    What is the exclusion that Congress created with the Mortgage Forgiveness Debt Relief Act in 2007? The qualified principal residence indebtedness exclusion.

    What exclusion expires on Dec 31? The qualified principal residence indebtedness exclusion.

What exclusion was in place in 2006, before the Act was passed, and will be in place after the Act expires? The insolvency exclusion.

Now, does the insolvency exclusion cover everyone that the qualified principal residence indebtedness exclusion covers? No, it does not. But if it doesn’t cover everyone, why would I say it doesn’t matter for most people doing a short sale? Two reasons:

  • The first reason is that most people doing a short sale are doing that short sale because they areinsolvent. That’s why their lender is agreeing to the short sale. Because the owner is insolvent.
  • The second reason covers the rest of the people, the ones who aren’t insolvent, as defined by the IRS. If 80% of owners doing a short sale are insolvent, most of the remaining 20% are doing a short sale because they have to. They are not making a choice between keeping the property and selling it. Keeping the property is not an option for these owners. They are faced with a choice of selling via short sale, giving the property back to the bank via a deed-in-lieu, or losing it via foreclosure. In all three of these outcomes, the lender has a choice: forgive the debt or pursue a judgment if available in that state. If the debt is forgiven, it is reported to the IRS as income to the former owner IN ALL CASES.

That means that our seller above, whose agent wrote to us, and who says she will refuse to go forward after Jan 1 because of the taxes may have been given bad advice. If this seller has the ability to keep the property, then perhaps she should refuse to go forward. But if like most sellers she cannot afford to keep the property, then the short sale should go forward, because even if she’s exposed to taxes, she’s exposed to them with a short sale or a foreclosure.

And, further, with a short sale, the sale will generally result in a higher payoff of the mortgage (which is why the servicers, lenders, and their investors are doing them). That means that the amount of debt to forgive will be less, which results in less tax exposure.

Don’t buy the fear. There may be another fiscal cliff coming in the new year, but for the vast majority of sellers, there is no tax cliff January 1 for short sales.

Notice: This article is not intended as legal or tax advice for you or your specific situation. If you need tax or legal advice, you should consult your accountant or attorney

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