Mortgage Forgiveness? Not So Fast

by Tyler Belong
June 18th, 2008

The “F” word continues to roll off of the tongue of more and more homeowners as notices of default continue to be recorded in record numbers and with no sign of letting-up. However, many are attempting to avoid foreclosure by taking advantage of the Mortgage Debt Forgiveness Relief Act passed in December of 2007 — legislation that allows under-water borrowers to avoid hefty capital gains taxes as a result of obtaining debt forgiveness from their lender.

In simple terms, the Act works as follows: The borrower owes more money to the lender than the borrower’s home is worth. Then the borrower accepts an offer to sell the property to a third-party buyer for less than the borrower owes to the bank. For example, the borrower might have a mortgage of $400,000 and accept an offer to sell the property for $300,000. If the Bank approves of the purchase and forgives the borrower of the deficient amount that would otherwise remain owing to the bank (a total forgiveness of $100,000), it used to be the case that the borrower would have to claim that $100,000.00 as income and pay taxes on it.

However, the Act saves the borrower from having to pay taxes on that forgiven debt so long as several criteria are met. First, the debt must be forgiven between 2007 and December 31, 2009. Second, the debt must be acquisition Qualified Principal Residence Indebtedness, which means that the principal balance of the entire debt was less than $2,000,000. Third, the forgiveness of the debt must not be the result of any factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer.

It is this third requirement that may preclude many borrowers from benefiting from the Act.

According to the IRS’ interpretation of the new Act, a borrower who receives forgiveness of a refinance loan (as a posed to a purchase money loan) will qualify for the Act’s protection so long as the refinance amount was not greater than the amount that the property is worth at the time of refinance. Additionally, the debt cannot have been used to provide cash to the borrower for anything other than improvements on the home. The problem that many borrowers will face as they try to sell their homes short and claim relief under the Act is that they obtained “cash-out” refinancing and applied that cash to items other than their home.

Any borrower who is contemplating a short sale and believes that any portion of the refinance money they received did not go back into their home should think twice before assuming they will automatically receive relief from taxes under the Act. If a borrower has any doubt as to whether or not they should sell their home short and accept debt forgiveness from their lender, they should first contact an experienced tax advisor, real estate attorney, or tax attorney. More information regarding the Act can be found at the IRS website: http://www.irs.gov/individuals/article/0,,id=179414,00.html


Attorney Tyler F. Belong is a partner at the San Diego law firm of Hogue & Belong. Mr. Belong is also a founder of the Mortgage Accountability Association.

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7 Responses to “Mortgage Forgiveness? Not So Fast”

  1. Paul Gellert Says:

    I am writing an article on Reverse Mortgages. The question is, in the event the house is worth less than the mortgage at the time of death or sale, is the forgiven amount taxable under the reverse mortgage rules? If it is, am I correct that the Mortgage Debt Forgivness Act would cover it?

  2. Dennis Haber Says:

    Inherent in the reverse mortgage rules is a special concept of no personal liability. Whenever the “upside down” event occurs (the amount due is greater than the value of the home at time of sale), under the FHA requirements, the
    lender will look to the government for the difference. Under the proprietary program, the lender will take the loss. The HECM (FHA) program requires mortgage insurance to cover this eventuality. The proprietary program today are offering lower LTVs, to prevent the crossover point from being reached.

  3. glenn Says:

    I am wondering if the Lender would considering “forgiving” the downside of the loan to the original owner at a slight premium to market value so he can keep his home? Or is this what the bill states?

  4. glenn Says:

    Are there answers to this question. This is my primary home, I rent another for work related reasons in another state. I do not rent it out nor would I. I am however looking at a house that was worth $320K, I have $250 financed and it is now worth maybe $140K. House is in Cape Coral, FL

  5. Mike Says:

    I wondered why my deadbeat brother in law was allowing his primary residence to be foreclosed upon because he no longer feels like working 40 hour weeks. I’ve been trying to explain to him that the $100k he is upside down would count as taxable income. Guess I am wrong after all. My guess is he is not alone and many who could pay their mortgages are walking because it is easier to walk – making the situation worse for taxpayers and lowering their neighbors property values. I hope he is in the minority and most cannot pay their mortgages rather than finding their debt repayment obligations inconvenient.

  6. JoAnn Says:

    I just went through a mortgage remodification with Bank of America because I was in forclosure. They put the money I owed in the back end of my mortgage. The problem now is that I Now owe more than my house is worth and my payment have gone up. I could hardly pay the orginal amount before and now it’s up almost $200 more. I took it only because I do Not want to lose my house, but I am going to be in trouble again if I can’t figure something out. Can You help?

  7. Katie Homes Says:

    Thanks for the info its good to share. Can I ask you a rhetorical question about yourself? do you mind?

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