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1 1 (January 14, 2021)

handle is hein.crs/govebrw0001 and id is 1 raw text is: r~s~k~ntd ~esear~h Servo Updated January 14, 2021 The Tax Treatment of Canceled Mortgage Debt Historically, if a lenderforgives orcancels mortgage debt (and most other debts), taxlaw has treated the amount of canceled debt as acancellationofdebtincome (CODI) subject to ordinary income taxrates. Section 108 of the Internal Revenue Code (IRC) contains two exceptions that are particularly relevantin the case ofcanceled home mortgage debt: a borrower may exclude canceled debtfrom gross income if (1) the debt is discharged in Title 11 bankruptcy; or (2) the borro wer is insolvent (that is, has liabilities that exceed the fair market value ofhis or her assets, determined immediately prior to discharge). These exceptions are permanent taxprovisions. Near the beginning of the housing downturn and Great Recession, Congress enacted a temporary provision that provided distressed borrowers another option for excluding canceled mortg age debt. This provision has been extended a number of times since its original enactment, most recently by the Consolidated Appropriations Act, 2021 (P.L. 116- 260), which extended it through the end of 2025. The latest extension alsoreduced themaximum amount of debt that qualifies for the exclusion. This In Focus provides a brief overview of the taxtreatnrnt of canceled mortgage debt. Cancelation of Indebtedness Income 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 andthelender agrees to forgive any debt outstanding thatthe sale price does not cover. Both principalreductions and short sales often resulted in canceled mortg age debt and, as a result, CODI subject to tax. Other efforts, such as extending the termof the loan or interes trate 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 andprovided 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, fromowing taxon top of existing financial distress. Theprovision was originally effective for debt dischargedbefore January 1,2010. The exclusion for canceled mortg age debt was subsequently extended severaltimes, most recently in the Consolidated Appropriations Act, 2021 (P.L. 116-260), which extended it through the end of 2025. The Joint Committee on Taxation (JCT) estimated this extension willreduce federaltax revenues by $2.8 billion between 2021 and 2030. The exclusion applies to qualified residential indebtedness, which is defined as debt, limited to $750,000 ($375,000 if married filing separately), incurred in acquiring, constructing, or substantially improving the taxpayer's principalresidence that is securedby suchresidence. Prior to P.L. 116-260 the exclusion was limited to $2 million ($1 million if married filing separately). Eligible debt also includes mortgage debtresulting froma refinancing, to the extent that therefmancing does not exceed the amount ofrefmanced indebtedness (e.g., cash- out refinance). Taxpayers are requiredto reduce the basis in theirprincipalresidence by the amount oftheexcluded 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 orto the taxpayer's financial condition. An Example An example may be helpfulin demonstrating the tax implications when CODIis not excluded fromtaxation. 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 dis charged debt, $20,000, is income subject to taxif no exclusion applies (e.g., the taxp ayer is not insolvent). If a 24% marginal tax rate is assumed, then thehomeowner would have a taxliability of $4,800 ($20,000 multiplied by 24%) from the debt cancelation. Alternatively, the home couldhave been sold as a result of foreclo sure 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. Still assuming a 24% marginaltax rate, it would generate the same taxliability as in the previous scenario. This is in addition to any taxes the taxpayer may owe on the gain fromthe sale of the house. Policy Issues Rationales put forth when the exclusion provision was originally enacted included minimizing hardship for distressedhouseholds, lessening the risk that nontax homeownership retention efforts would be thwarted by tax policy (e.g., short sales), and assisting in the recovery of the housing market and, in turn, the overall economy. Arguably, these s ame rationales still apply in the current environment.

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