New tax breaks provide relief to homeowners

Homeowners found three attractive tax breaks among their holiday presents, thanks to the federal Mortgage Forgiveness Debt Relief Act of 2007, which was enacted in December.

The first tax break concerns forgiveness of debt, which occurs when a lender forgoes repayment of principal and/or interest the borrower owes.

Typically, discharged debt is considered ordinary income to the borrower for income tax purposes.

The new law allows taxpayers to exclude this amount and thus escape the tax liability.

"When you're worried about making your payments, higher taxes are the last thing you need to worry about.

"So this bill will create a three-year window for homeowners to refinance their mortgage and pay no taxes on any debt forgiveness that they receive," President Bush said in his remarks upon signing the law.

Three new tax breaks:

1. Homeowners who experience a foreclosure, short sale, deed in lieu of foreclosure or loan modification may be able to exclude lender-forgiven mortgage debt from taxable ordinary income.

2. Homeowners may be able to deduct the cost of mortgage insurance.

3. A homeowner whose spouse has died may be allowed up to two years to exclude $500,000 of profit from the sale of a principal residence from capital gains tax.

Lenders are required to report forgiveness of debt to the Internal Revenue Service, which means taxpayers likely will need to note the amount and the reason for the exclusion on their tax returns.

Consult a qualified tax professional for more information and advice about your situation.

Rules for debt forgiveness:

-- The debt must have been discharged by the lender in 2007, 2008 or 2009.

-- The amount of debt that can be excluded is limited to $2 million.

-- The exclusion can be used only if the loan was taken out to acquire, build or substantially improve a principal residence. Forgiveness of debt on vacation homes, second homes and investment property doesn't qualify.

-- Debt forgiven on a cash-out refinance or home equity loan must be apportioned between the amounts used for home acquisition, construction or improvement and amounts used for other purposes such as tuition, travel or repayment of other debts. Only the allowable portion qualifies for the tax break, says John W. Roth, a senior tax analyst at CCH, a provider of tax services, software and information in Riverwoods, Ill.

Exceptions allowed for nonrecourse loans, insolvency, bankruptcy

It's difficult to figure out how many people might qualify, because three existing exemptions already shielded many homeowners from this tax liability, according to Sterling Watkins, mortgage broker and owner of Short Sale Services in Folsom, Calif.

"In my experience, the amount of people who will benefit will be small because most of them, if they qualified for a short sale, didn't have a (tax) problem," he says.

There are three main existing exemptions.

First, in some states, such as California, all purchase-money home loans are required to be "nonrecourse" debt, which means the lender can't pursue the borrower for additional money that's still owed after the property is sold.

A "recourse" loan, on the other hand, means the borrower is personally responsible for the debt and must pay the difference if the sale of the property doesn't pay off the balance that's owed to the lender.

"In Texas, for example, which is one of the recourse states, they have a different attitude about collecting loans. They basically follow you around until they get the money back. They still do short sales and they accept discounts to avoid having to chase someone, but they bargain from a different perspective," Watkins says.

The distinction is crucial because the lender can pursue the debt on a recourse loan even if a foreclosure or short sale occurred; but without recourse, there is no debt to be forgiven and thus no ordinary income tax liability for the borrower.

The new tax break means borrowers who have a recourse loan also can avoid the tax liability.

Second, borrowers who are insolvent are relieved from ordinary income tax liability on forgiveness of debt to the degree of their negative net worth, Watkins explained.

For example, an individual whose assets totaled $400,000 and whose debts totaled $500,000 would have a negative net worth of $100,000. Forgiveness of debt on a principal residence acquisition loan up to that amount wouldn't be subject to federal income tax.

Third, forgiveness of debt tax liability is wiped out if the taxpayer files for bankruptcy. That's not a free ride, because bankruptcy is subject to its own costs, hassles and credit implications.

A capital gain that resulted from a foreclosure, short sale or deed in lieu of foreclosure may still be subject to taxation. This situation is rare, since homeowners who experience these events typically owe more than their home is worth and any capital gain might be subject to a separate exclusion.

"Even though you have forgiveness of debt (excluded) as ordinary income, if you do a short sale or foreclosure, that money would be considered part of the proceeds from the sale of the property, so you could theoretically still have some capital gain on a short sale or foreclosure without going into bankruptcy or being insolvent," Roth says.

The second tax break concerns mortgage insurance, which is paid for by the borrower, but protects the lender if the borrower defaults on the loan.

The new law extends a one-year deduction of mortgage insurance premiums that was effective in 2007 for three more years, 2008, 2009 and 2010. That time frame means the deduction is allowable only for mortgage insurance on loans that were originated after Dec. 31, 2006, and before Jan. 1, 2011, unless the tax break is further extended in the future.

The full deduction is available only to taxpayers whose adjusted gross income is less than $100,000.

A partial deduction is allowed for adjusted gross incomes up to $109,000. The deduction is worth $350 for the average taxpayer, according to Mortgage Insurance Companies of America, an industry association.