What am I missing here?

Am I missing something concerning the Mortgage Forgiveness Dept Relief
Act of 2007? The upshot is that on foreclosure of someone's residence,
debt not required to be repaid is not considered income as long as the
debt was used to purchase or fix up the house (directly or indirectly,
meaning it went into the basis of the house).
It seems to me that act really had no real effect with respect to
forgiveness of debt income on home mortgages. There should only be
income to the extent the forgiven debt exceeds the debtor's basis in
the property. And if the act only applies to debt that went into or
increased the basis, none of that forgiven debt would have had to be
recognized as income in any case.
So what was the purpose of the statute really? Does it have an actual
effect?
Thanks for your insight.
Stu
Reply to
Stuart A. Bronstein
Your error is where you say "There should only be income to the extent the forgiven debt exceeds the debtor's basis in the property." You seem to have confused two issues: Debt cancellation and gain or loss on the sale of real property.
If you have a recourse loan on your home and debt is forgiven, you normally have debt cancellation income. The referenced tax act allows for forgiveness of that debt if all conditions are met. Any forgiveness must then be used to lower the cost basis of the home. The home owner then makes another calculation to determine whether or not there was a gain on the disposition. If there was a gain, the home owner can exclude that gain if the two year rules for excluding gain on your main home are met.
IRS Pub 4681 (Canceled Debts, Foreclosures, Repossessions and Abandonments) has a very good explanation and examples of the tax consequences relating to the Pub subject.
Reply to
Alan
That's what you are missing. Before this act, the full amount of canceled debt was taxable income, now it's not (for three years only, 2007-2009). The amount excluded from income under this law is used to reduce the basis in the property. The gain if any due to this reduced basis, however, typically will fall under the normal Sec. 121 exclusion rule.
Wrong, prior to the act there was no special rule regarding acquisition debt on a principal residence. It was all still just cancellation of debt income.
One way to think of it, is that it has the effect of making short sale or foreclosure of a house with recourse debt behave as if it were non-recourse debt for tax purposes.
For states like California which did not conform to the federal law, any cancellation of debt income excluded on the federal return must be added back for the state return.
-Mark Bole
Reply to
Mark Bole
Perhaps. But it seems to me that in the case of, say, a single purchase money loan, when the home is foreclosed on, it's in effect a sale of the home back to the bank for the amount of the outstanding debt. In that case how can there be debt cancellation income without gain? That would be like saying that anyone who sells a house with a mortgage on it has income in addition to their gain.
I guess that's part of my problem with this - exactly when is debt "forgiven"? If someone gives value in exchange for cancellation of debt, for me that's an exchange and there's only tax if there is gain.
Thanks.
Even that publication says there should only be cancellation of debt income if the amount owed is less than the fair market value of the property. So why is there no offsetting loss on the "sale" of property for less than basis? You may not be able to deduct the loss from taxes, but shouldn't it be allowed to offset any gain?
Stu
Reply to
Stuart A. Bronstein
That might have been the theory. But as I said to Alan, it seems to me that any foreclosure (or equivalent) is in effect a sale to the lender for the amount of the outstanding debt. Whenever you sell a property subject to a mortgage, the debt is "cancelled" but without incurring tax on that "gain."
Why should it be different when the lender buys it from the debtor?
I understand that. But how could it be taxable if the "gain" was offset by the debtor's basis on the property?
Say you have a house with a basis of $100,000 secured by a loan of $100,000. You do a short sale for $80,000. You technically have cancellation of debt income of $20,000. But you also have a loss of $20,000. Why doesn't the loss offset the gain?
Stu
Reply to
Stuart A. Bronstein
On May 12, 10:29 am, "Stuart A. Bronstein" wrote:
A foreclosure or short sale involving a debtor who is not otherwise insolvent would normally be seen by the IRS as a transaction with two components:
- A sale at a price probably below the basis, but this generates a non- deductible personal loss. - Debt forgiveness which results in taxable income for the amount that the debt was greater than the sales proceeds.
The Act of 2007 basically makes the debt forgiveness non-taxable to the extent that the borrowing was for purchase money or home improvement.
Say you bought the house for $200k, borrowed $150k and then when the market boomed, you refinanced and borrowed another $150k, because your house could appraise at $350k without any improvements. You spent the $150 on an investment property, college tuition for the kids, travel around the world for six months etc. Then the market crashes, you have a short sale for $250k, and the bank forgives $50k. You still pay tax on the $50k.
But if you bought a house for $350k, borrowed $300k, and then the market crashes, you have a short sale for $250k, and the bank forgives $50k. Without the Act of 2007 you would have $50k in debt forgiveness income (taxable) and a non-deductible loss of $100k, which may very well mean a tax bill of $35k. If you weren't insolvent before (excluding the mortgage) you may very well be insolvent now, and be driven into bankruptcy. Then things get worse because your tax debt isn't discharged in bankruptcy either. Your better option would have been to forgo the short sale, and go into foreclosure and bankruptcy in the first place. This is a worse outcome not only for you but from the point of view of the economy as a whole. There is a deadweight economic loss from the foreclosure compared with a short sale, but the tax consequences make the short sale worse for the homeowner.
Reply to
TheMightyAtlas
[...]
Only if it's a non-recourse loan. Remember, just because your property is foreclosed doesn't mean the bank has stopped going after you for the rest of the money if it's a recourse loan. Cancellation of debt can take place quite some time after the foreclosure sale.
Whenever you sell a
"canceled" = "forgiven", not "paid off".
[...]
As someone else already pointed out, the loss is a non-deductible personal loss.
-Mark Bole
Reply to
Mark Bole
In article , snipped-for-privacy@lexregia.com (Stuart A. Bronstein) writes:
| But as I said to Alan, it seems to | me that any foreclosure (or equivalent) is in effect a sale to the | lender for the amount of the outstanding debt.
I think these "substance over form" or "economic reality" arguments generally apply only against the taxpayer and if made by the IRS-- sometimes to only one side of the transaction. :)
Dan Lanciani ddl@danlan.*com
Reply to
Dan Lanciani
The terminology confuses me some times. To be precise, with a non-recourse loan, the amount of debt canceled becomes the "sales price" considered to have been received, and there is no *income* from cancellation of debt (although there will usually be a gain or loss on the "sale" of the property). With a recourse loan, the sales price considered to have been received is the FMV, and if the amount of debt canceled is more than the FMV, the difference is taxable income due to cancellation of debt.
I believe that is "more than", not "less than". Or give us a page number in the PDF file to refer to. But otherwise, yes, cancellation of recourse debt is taxable income to the extent it exceeds the FMV of the property surrendered. Again, cancellation of non-recourse debt does not normally lead to any taxable COD income.
As I said before, in reply to your original post, the 2007 tax law had the effect of making cancellation of recourse debt that met the requirements end up being treated like non-recourse debt for this purpose (I'm oversimplifying, but the end result looks the same for tax purposes). The canceled recourse debt that did not meet the requirements (acquisition debt on primary residence) still can generate COD income.
The gain or loss on the "sale", and income from cancellation of debt, are two different things. The latter is not gain from sale of property.
As we know, the gain on sale of personal residence gets favorable treatment under both Sec 121 and long-term capital gains tax rates. Income from cancellation of debt gets no such treatment. The 2007 law moves some income out of the latter category into the former, under the right limited conditions -- similar to what would happen with a non-recourse loan even before the 2007 law.
-Mark Bole
Reply to
Mark Bole
Actually, California has partially conformed to the federal Mortgage Forgiveness Debt Relief Act of 2007 (SB 1055, Ch. 282, Stats. 2008). 2007 returns can be amended to claim refunds available under the new law.
Differences between California and federal law are the following:
· "Qualified principal residence indebtedness" is limited to $800,000 ($400,000 MFS) as opposed to $2 million/$1 million federal. · The maximum COD income exclusion is limited to $250,000 ($125,000 MFS); there is no maximum for federal purposes. · The California exclusion is available for 2007 and 2008 only, not 2009.
For federal purposes, a taxpayer may elect to use the insolvency rules under IRC Sec. 108 rather than the principal residence exclusion rules. A different election may be made for California than for federal purposes.
Katie in San Diego
Reply to
Katie
Heh... it's so slow around here this time of year, I have to correct my own mistakes.
"The federal law previously covered debt forgiven from 2007 through 2009. On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (H.R. 1424) extended the federal period through 2012."
California as of now partially conforms, only for years 2007-2008 and with lower limits.
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-Mark Bole
Reply to
Mark Bole

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