Tax Consequences of Mortgage Modification

June 30, 2011

An Alternative to Foreclosure – Loan Modification

In today’s housing crisis, foreclosure has become an everyday term. However, it is not the only answer for homeowners who can’t make their mortgage payments. For homeowners who want to fight to keep their homes, there are opportunities to change their existing mortgage arrangement, including pursuing a loan modification (wherein the terms of a home loan would be renegotiated) or a short-sale (an option where the bank agrees to sell the house for less than what is owed on the mortgage).

What is a loan modification?

A loan modification, as the name suggests, is a process by which the terms of an existing loan are modified, to allow the borrower to continue paying his mortgage.  Loan modification can include a permanent or temporary reduction in the interest rate, the principal loan amount, an extension of the terms of the loan, or most commonly a combination of all three.  This program applies to borrowers who are unable to make — or are struggling to make — mortgage payments that exceed 38% of their monthly income.  If the lender agrees to lower the interest rate or reduce the principal amount to bring the payment to 38% of the borrower’s income, the government will pay half of the additional cost to the lender to reduce the payment to 31% of the borrower’s income.  Although a difficult and time consuming process, a loan modification is one of the best options for homeowners wanting to stay in their homes.

Tax Implications of a Loan Modification

Prior to December 2007, a homeowner would have been liable to pay income taxes on the difference between the original loan amount and a later-modified loan.  The Mortgage Debt Relief Act of 2007 was enacted to allow taxpayers to exclude up to $2 million (if married filing jointly) of income from the cancellation of debt on their principal residence in 2007 through 2012.  Debt reduced through mortgage restructuring (loan modification), as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.   All forgiven debt must be reported on IRS Form 982 and attached to your tax return.  Second homes and investment properties do not qualify for the Mortgage Debt Relief Act and any cancellation of debt may be taxable. 

For more examples and details on the tax implications of loan modifications you can consult IRS Publication 4681 (Canceled Debts, Foreclosures, Repossessions, and Abandonments).  At Wallace & Associates, it’s our mission to provide all of your taxation and accounting needs, and have the latest information to keep you compliant and timely with filings.

In case you need advice on how a foreclosure affects your taxes or accounting, contact Wallace & Associates Certified Personal Accountants serving the Los Angeles area.
Check out our blog post about foreclosure tax consequences.