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1 1 (May 05, 2020)

handle is hein.crs/govdaca0001 and id is 1 raw text is: ,..........s .--- ,- Se. May 5, 2020 The Tax Treatment of Canceled Mortgage Debt Recent data indicate that the economy is weakening and that labor markets are under a great deal of strain as fallout from the COVID-19 outbreak continues. The corresponding drop in incomes is causing financial hardship for some homeowners as they struggle to make timely mortgage payments. Included in the broader third round of economic relief known as the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) were temporary forbearance for federally backed single-family and multifamily mortgages and a temporary foreclosure moratorium for federally backed single-family mortgages. These provisions are discussed in CRS Insight INi 1334, Mortgage Provisions in the Coronavirus Aid, Relief and Economic Security (CARES) Act, by Katie Jones and Andrew P. Scott. Once these temporary efforts to assist homeowners expire, there may be an increased number of home foreclosures, mortgage defaults, or mortgage modifications barring additional relief efforts. Attempts to resolve mortgage indebtedness concerns may result in cancellation of debt, which can have important tax consequences. This In Focus provides a brief overview of the tax treatment of canceled mortgage debt. Historically, if a lender forgives or cancels mortgage debt (and most other debts), tax law has treated the amount of canceled debt as a cancellation of debt income (CODI) subject to ordinary income tax rates. Section 108 of the Internal Revenue Code (IRC) contains two exceptions that are particularly relevant in the case of canceled home mortgage debt: a borrower may exclude canceled debt from gross income if (1) the debt is discharged in Title 11 bankruptcy; or (2) the borrower is insolvent (that is, has liabilities that exceed the fair market value of his or her assets, determined immediately prior to discharge). These exceptions are permanent tax provisions. In response to the housing market turmoil of the late 2000s, some lenders made efforts to work with borrowers and avoid foreclosure. Examples of these efforts included principal reductions, which allow the homeowner to remain in the home, and short sale transactions. In a short sale, the property is listed for sale and the lender agrees to forgive any debt outstanding that the sale price does not cover. Both principal reductions and short sales often resulted in canceled mortgage debt and, as a result, CODI subject to tax. Other efforts, such as extending the term of the loan or interest rate reductions, however, generally did not result in CODI. In December 2007 the Mortgage Forgiveness Debt Relief Act of 2007 (P.L. 110-142) was enacted and provided a temporary exclusion for qualified canceled mortgage debt. This was intended to prevent homeowners who were granted principal reductions, or who entered into short sale agreements, from owing tax on top of existing financial distress. The provision was originally effective for debt discharged before January 1, 2010. The exclusion for canceled mortgage debt was subsequently extended several times, most recently by the Further Consolidated Appropriations Act, 2020 (P.L. 116-94). That law extended the exclusion for canceled mortgage debt through the end of 2020. The exclusion applies to qualified residential indebtedness, which is defined as debt, limited to $2 million ($1 million if married filing separately), incurred in acquiring, constructing, or substantially improving the taxpayer's principal residence that is secured by such residence. It also includes refinancing of this debt, to the extent that the refinancing does not exceed the amount of refinanced indebtedness (e.g., cash-out refinance). Taxpayers are required to reduce the basis in their principal residence by the amount of the excluded income. The provision does not apply if the discharge was on account of services performed for the lender or any other factor not directly related to a decline in the residence's value or to the taxpayer's financial condition. Ank,, ETampke An example may be helpful in demonstrating the tax implications when CODI is not excluded from taxation. Consider a homeowner with a current mortgage balance of $200,000. The lender agrees to a loan restructuring that cancels $20,000 in debt and reduces the homeowner's loan balance to $180,000. The discharged debt, $20,000, is income subject to tax if no exclusion applies (e.g., the taxpayer is not insolvent). If a 24% marginal tax rate is assumed, then the homeowner would have a tax liability of $4,800 ($20,000 multiplied by 24%) from the debt cancelation. Alternatively, the home could have been sold as a result of foreclosure along with a lender agreement to cancel the remaining debt. If the home were to sell for $180,000 then this would result in $20,000 of remaining debt. The $20,000 of discharged debt would be income assuming no exclusion applies, and also still assuming a 24% marginal tax rate, would generate the same tax liability as in the previous scenario. This is in addition to any taxes the taxpayer may owe on the gain from the sale of the house. pofc Issues Rationales put forth when the exclusion provision was originally enacted included minimizing hardship for distressed households, lessening the risk that nontax N 1 10 NLI,

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