Short Sale Tax Relief: Update on the Mortgage Forgiveness Debt Relief Act / Mortgage Cancellation Relief Act

Disclaimer: I am by no means an attorney, a tax professional, nor a politician. What follows is my interpretation of the Mortgage Forgiveness Debt Relief Act of 2007. As always, consult your attorney and tax professional for specific questions! And if you think it will help to consult your politician, well… knock yourself out!

My recent post on the Mortgage Cancellation Relief Act generated several questions asking for clarification. Questions fell into two primary areas: 1) which of the two acts will be sent to the President for signing; and 2) what is the definition of “primary residence” and will this act cover my personal situation.

Question #1 is the easiest to answer. The House version of the bill (H.R. 3648), titled the Mortgage Forgiveness Debt Relief Act of 2007 was amended by the Senate and as of yesterday (Dec 19) was sent to President Bush for signing into law.

Here is the entire text of the bill as sent to the President.

Everything I’ve read indicates the President will sign this bill into law. UPDATE: President Bush signed the bill into law as I was writing this post. Here are his remarks.

Question #2 requires some interpretation and again, I’m no lawyer or politician. Bills and IRS Codes contain language that only graduates of Politi-speak 401 and those fluent in IRSeese can fully comprehend.

Here is an example from the bill:

Paragraph (1)(B) shall not apply to a discharge to which paragraph (1)(E) applies unless the taxpayer elects to apply paragraph (1)(B) in lieu of paragraph (1)(E).’.

And I’m not even going to quote from the two sections of applicable IRS Code (sections 108 and 121). Read them at your own risk.

I have read the bill in its entirety and cross-referenced the IRS Codes, well past the point of getting a massive headache, and here’s what I think in highly condensed normal people English.

The Mortgage Forgiveness Debt Relief Act removes the potential tax liability associated with a “short sale”. To borrow the example from my previous post, that tax liability plays out like this:

Say Joe Homeowner owes $300,000 on his mortgage. His lender approves a “short sale” that will net the lender $250,000. But Joe owes $300,000. The lender “forgives” this $50,000, but is required to report that to the IRS. Our buddies at the IRS then say, “Hey Joe, you owe taxes on that $50K, pay up!”.

Depending on Joe’s tax bracket, the taxes owed on that $50,000 in forgiven debt could run into the thousands (potentially many thousands).

There are, of course, some limits and restrictions….

The maximum amount of “forgiven debt” is $2,000,000. I *think* this is for a married couple filing jointly and the limit for a single person is $1,000,000. Regardless, I doubt these limits will impact many.

The bill only applies to a “principal residence”. So investment properties and second homes in a short sale situation are not eligible. This leads to the obvious question of “what is a principal residence?”

From the bill:

`(5) PRINCIPAL RESIDENCE- For purposes of this subsection, the term `principal residence’ has the same meaning as when used in section 121.’.

When I first read the bill, I thought this was referencing “section 121″ of the bill itself. But there is no section 121 in the bill. So it appears to be referencing Section 121 of the IRS Code, which actually makes sense because IRS 121 defines “principal residence” as:

“. . . during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more. “

In short, if you lived in a home you own for 2 of the past 5 years (from the date of sale), it is considered a principle residence. Note the word “aggregating”. That means you don’t have to have lived in the home for two consecutive years in the past 5. Simply go back 5 years from the date of the sale and if you lived in the home for a total of 2 years, it qualifies as a primary residence.

Now someone who owns two homes may be thinking, “Hey, I’ve lived in one house for 2 of the last 5 years and in the other one for 3 of the last 5 years. They are BOTH primary residences!”

Trust me, the IRS has thought of that. My understanding is you have to declare one or the other as your primary residence. They aren’t going to let you have two eligible primary residences.

Important note: The bill clearly states, ” (d) Effective Date- The amendments made by this section shall apply to discharges of indebtedness on or after January 1, 2007.”

So if you had a short sale prior to January 1, 2007 you are apparently out of luck with regard to tax relief from this act.

There is much more gobbledygook in both the bill and the IRS codes. But the gist of it is this:

If you were in a short sale situation after January 1, 2007, and it involved your primary residence, then you will not be liable for taxes on the amount of the forgiven debt as long as it is less then $2 million dollars.

Also included in this bill is an extension of the mortgage insurance premium deduction through 2010 (was slated to end this year). There are also changes to things like S Corp filing penalties, tax benefits for volunteer firefighters and emergency medical responders and more, but my head hurts far too much to even attempt to decipher those sections. If you think they may apply to you, you know the drill about who to consult.

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Mortgage Forgiveness Debt Relief Act Passes US House

Do It Yourself Short Sale

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