Loan Modification? Beware the IRS

August 16, 2013

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As the economy continues to improve, and the housing market gets back to normal, hopefully there will be fewer and fewer homeowners who will find themselves so far underwater with their mortgages that they need to do something drastic or risk losing their houses.

One of the least extreme actions for a homeowner who wants to keep his house is the loan modification, in which an underwater homeowner will contact his lender and request that the lender adjust the loan to reflect the current market value of the house. This may require that the outstanding balance of the loan be lowered by tens of thousands of dollars, if the home has lost a significant amount of value.

Loan Modification Options

A loan modification can take many forms. In some cases, it will involve a reduction in the interest rate, either temporarily or permanently. The loan terms can be modified, perhaps to stretch a 15-year term into a 30-year loan. Or, in some cases, the actual principal can be reduced to fall in line with current market rates.

There are generally certain guidelines that a homeowner must meet in order to qualify for a loan modification:

• Must have experienced a documented hardship or change in financial circumstances

• Must have missed three payment (90 days delinquent) or more

• Must own and occupy the property as a primary residence

• Must not have filed bankruptcy

Big Drawback

If the mortgage lender can be persuaded to accept a lesser amount for the loan, this is known as debt forgiveness, and the amount of debt that is forgiven is generally considered taxable income to the homeowner, which can cause all sorts of problems when tax time comes around.

For example, a homeowner has a mortgage with an outstanding balance of $150,000 in principal. He successfully negotiates with his lender to reduce the balance to $100,000 because of a decline in the value of the house. The $50,000 in debt that the bank has essentially eliminated is now taxable income to the homeowner;  this will likely cause him an immense deal of trouble at tax time, when his taxable income has suddenly skyrocketed.

Congress Helps Out

In 2007, a prescient Congress passed the Mortgage Forgiveness Debt Relief Act, which worked to eradicate the “income” that was generated by the debt forgiveness under most circumstances.

The Act was targeted to mortgage debt that was forgiven in the years 2007 to 2012, and for amounts of up to $2 million for a couple that files their income tax returns jointly (only $1 million for couples that file separately.)

Exceptions to the Rule

The forgiveness does not apply if the debt was reduced for services rendered to the lender, or if the debt was forgiven for any reason other than a decline in the value of the house or a change in the homeowner’s financial situation.

Note also that the debt must be for purchasing, building or substantially improving the principal residence; any debt forgiven for a secondary home, or rental or business property, is not eligible for tax-free status. Likewise, any proceeds of a refinanced mortgage that were used for other purposes, like paying off credit card debt or  financing a vacation, do not qualify for tax exclusion.

Finally, this debt forgiveness tax exclusion applies only to home mortgages, not to credit card debt or car loans for which you may also have obtained lender modifications. The amount of debt forgiven by these lenders must be included and you must pay tax on it when you file your income taxes. These loans can only be excluded under certain situations involving bankruptcy or insolvency; please see a tax professional for more information.

The forgiven debt must still be reported when the homeowner files his taxes; IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, must be filled out and included with the homeowner’s income tax filing.

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Fiscal Cliff Act Averts End of Forgiveness Period

The Mortgage Forgiveness Debt Relief Act was originally passed in 2007 and was intended to expire at the end of 2012. At the last minute, Congress passed the Taxpayer Relief Act of 2013, and the IRS issued a clarification memo on March 12, 2013.

The Act extends the date for the exclusion of debt forgiven through January 1, 2014. Presumably, if the economy has not made further significant progress toward recovery by this time, Congress will be facing a similar deadline for extending the benefit into 2014 and beyond.

If you are involved in obtaining a loan modification for your home, please consult with a tax professional to make sure your are properly filing your income tax forms in order to take advantage of this potentially valuable benefit.