The Mortgage Debt Forgiveness Act
Homeowners who are concerned about their ability to continue to make their mortgage payments are usually familiar with the Mortgage Debt Forgiveness Act – a federal law. This legislation, due to expire on December 31, 2012, (unless renewed by the U.S. Congress), provides a tax break if there is cancellation of mortgage debt arising from debt forgiveness on one’s primary residence. But, most homeowners are not familiar with the fact that the IRS Code Section 108 offers a similar protection in many situations. This is important since there is still no indication whether Congress will renew the Mortgage Debt Forgiveness Act.
A person should understand that if (s)he does a deed-in-lieu of foreclosure, a short sale or a foreclosure where a portion of one’s debt is ‘forgiven’ or ‘cancelled’, then that amount of loan ‘forgiveness’ must be reported as ordinary income on that year’s 1040 income tax. If this debt forgiveness arises from one’s primary residence, the Mortgage Debt Forgiveness Act exempts the amount of debt forgiveness from being taxed as ordinary income. That is a substantial tax benefit.
The rationale behind taxing the amount of debt forgiveness is that the borrower received money (the loan) and did not pay any income tax upon the receipt of the loan funds. The assumption was that the loaned money would be repaid. Then, the loan funds were used to purchase a residence. However, later the loan is not only not paid back, but the debt is cancelled or forgiven. IRS views this as the borrower having now received money with no obligation to pay the funds back. Therefore, as of the time of the debt forgiveness or cancellation, IRS treats the debt forgiveness as taxable income to the borrower. This is sometimes referred to as phantom income. IRS would not want the borrower to have enjoyed the benefit of receiving money, not paying it back and not paying a tax on those funds. Naturally, the taxation of such moneys can be a substantial hardship to the borrower who is already in a position of not having been able to make the loan payments to the lender. In fact that is usually the reason the debt was ‘forgiven’ in the first place.
Section 108 of the IRS Code also deals with the subject of debt forgiveness. It too exempts the amount of debt forgiveness arising from the sale of one’s real property. One exemption involves debt forgiveness where the loan is a “non-recourse” loan. That term “non-recourse loan” is usually defined as a secured loan which prohibits the lender from suing the borrower to obtain other assets of the borrower if the value of the security falls below the amount required to repay the loan. This now leads us to a discussion about the Arizona anti-deficiency law.
In Arizona, due to the anti-deficiency law, lenders are prevented from recovering any deficiency (difference between the amount of the lender’s loan balance and the sale price of the home in a short sale or foreclosure) where a purchase money loan is involved. Therefore, in certain cases there is no debt that the lender can pursue in such a case where the anti-deficiency law applies. It has the effect of making the loan a non-recourse loan. The anti-deficiency applies only to loans used to purchase single one-family dwelling or a single–family dwelling on two and a half acres or less. In short, if the anti-deficiency law is in play then the lender may only look to the collateral, (the property) and cannot sue the borrower for any deficiency. This makes the loan what is called a “non-recourse” loan.
Why is it important for the loan to be non-recourse?
The reason is that if the loan is a non-recourse loan (due to the anti-deficiency law in Arizona) then it does not result in “cancellation” or “forgiveness” of debt since there was not a true debt to begin with since the borrower is not liable for the deficiency if the value of the security fall below what is necessary to pay off the balance of the loan. Thus, if the loan in Arizona is a qualified purchase money loan and the borrower cannot be sued by the lender for any deficiency then the borrower does not experience a true forgiveness of debt and does not have to worry about the applicability of the Mortgage Debt Forgiveness Act that is due to expire at the end of 2012 if it is not extended by the U.S. Congress. But – for tax purposes, the IRS will look at the remaining balance of the loan just prior to the short sale or the foreclosure and treat that as the “sales price”. From the “sales price”, the borrower subtracts the basis (less any accumulated depreciation) in the property. The borrower will be liable for the tax on the difference between the “sales price” and the adjusted basis of the property, if any.
The moral of this story is that in most (but not all) situations involving a primary residence with a purchase money mortgage, the property owner does not have to be concerned about the expiration of the Mortgage Debt Forgiveness Act on December 31, 2012.
Tax Law – Boring, but Complex
Yes, anytime you get into tax law the discussion gets not only boring but complex and difficult to understand. I would highly recommend consulting a certified public accountant who has experience in this area. Even the most qualified accountants consider this a difficult area to wade through since the IRS has not given a significant amount of clarification in their regulations to assist in the interpretation of the law.