WASHINGTON
With the Obama administration and private lenders now actively considering mortgage-principal-reduction programs to help financially distressed homeowners, the Internal Revenue Service has issued a new advisory to taxpayers who receive - or seek to receive - such assistance if it's offered.
The IRS gets involved in mortgage-principal write-downs because the tax code generally treats any forgiveness of debt by a creditor in excess of $600 as ordinary taxable income to the recipient.
However, under legislation that took effect in 2007, certain home- mortgage debt cancellations - such as through loan modifications, short sales or foreclosures - may be exempted from tax treatment as income.
But what are the tax implications when your lender essentially says: OK, we recognize you're underwater, maybe you're thinking about walking away, and we're going to write off some of what you owe to keep you in the house? IRS guidance issued March 4 spelled out step by step how financially troubled and underwater borrowers can qualify for tax relief when a lender agrees to lower their debt.
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Here are the basics, should you be considering a short sale or loan modification involving principal reduction:
To begin with, be aware that the federal tax exclusion only applies to mortgage balances on your principal residence - your main home - and not on second homes, rental real estate or business property. The maximum amount of forgiven debt eligible under the law is $2 million for married taxpayers filing jointly and $1 million for single filers.
But there are some potential snares: Your debt reduction can only be for loan amounts that you've used to "buy, build or substantially improve your principal residence." This includes refinancings that increased your total mortgage debt attributable to renovations and capital improvements of your house. But if you used the proceeds for other personal purposes, such as to pay off credit card bills, buy cars or invest in stocks, the mortgage debt attributable to those expenditures is not eligible for tax exclusion.
In all refinancings, make sure you can document where the money flowed.
When your lender formally forgives all or part of your mortgage balance, the lender is required by law to issue you an IRS Form 1099-C, a "Cancellation of Debt" notice, which is also sent to the IRS. The form shows not only the amount of debt discharged but the estimated fair market value of the house securing the debt as well.
If you've been foreclosed upon or you do a short sale and you lose money in the process, don't claim a tax loss on your federal filing. The IRS will turn you down. However, if you go to foreclosure and your lender agrees to cancel all or part of the unpaid mortgage balance as part of the deal, then you can file for an exemption from the IRS.
What if your lender reduces the debt on your house but you continue to own the property and live in it? There's a tax wrinkle in the fine print: The IRS will require you to reduce your "basis" in the house - your "cost" for tax purposes - by the amount of the forgiven debt. But that's not likely a big concern for most homeowners digging their way out of the bust.
Finally, if you want to claim the debt forgiveness exemption, download IRS Form 982 (available at www.irs.gov) and attach it to your return for the year in which the debt was forgiven. This tax code benefit expires at the end of 2012.
Contact syndicated columnist Kenneth Harney at kenharney@earthlink.net