Homeowners May Exclude Discharged Mortgage Indebtedness Under the Mortgage Forgiveness Debt Relief Act of 2007
Written by:
Eric L. Pruitt
Baker, Donelson, Bearman, Caldwell & Berkowitz, PC; Birmingham, Ala.
and
Matthew M. Cahill Cumberland School of Law; Birmingham, Ala.
The treatment of discharged mortgage indebtedness under the Internal Revenue Code (IRC) changed significantly with the enactment of the Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA). The MFDRA, by adding subsections (a)(1)(E) and (h) to IRC §108, allows the exclusion from gross income of discharged qualified principal residence indebtedness. The Internal Revenue Service (IRS) has also revised Form 982 to facilitate the change.
Under the new IRC §108(h)(5), the definition of “principal residence” is the same as under IRC §121. Debt relief related to second homes, business property, credit cards or car loans can not be excluded; however, exclusion may still be possible under other provisions of IRC §108 (e.g., the insolvency provision under IRC §108(a)(1)(B)). The term “qualified principal residence indebtedness” is defined as acquisition indebtedness within the meaning of IRC §163(h)(3)(B) as applied to the taxpayer’s principal residence. IRC §108(h)(2).
Debts discharged in 2007, 2008 or 2009 are eligible for the principal residence exclusion. IRC §108(a)(1)(E). The amount which may be excluded is limited to $2 million or $1 million for married individuals filing separate returns. IRC §108(h)(2).
The qualifying amount includes the original indebtedness incurred in the acquisition, construction or substantial improvement of the taxpayer’s principal residence, as well as the refinancing of such debt. IRC §163(h)(3)(B). However, refinancing in excess of the original indebtedness does not qualify for exclusion. Id. Furthermore, if a loan that includes qualified and non-qualified indebtedness is discharged in part, then the exclusion applies only to the portion of the discharge in excess of the amount of the nonqualified part of the loan. IRC §108(h)(4). In other words, in the case of partial discharge, any nonqualified portion of the loan is assumed to be discharged first. An example of this situation is provided on IRS Form 982.
Any amount excluded under the MFDRA is applied to reduce (but not below zero) the basis of the taxpayer’s principal residence. IRC §108(h)(1).
No principal residence exclusion is available for loans discharged “on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer.” IRC §108(h)(3).
If the taxpayer is insolvent when the loan is discharged, the principal residence exclusion takes precedence with respect to eligible loans, unless the taxpayer elects instead to apply the insolvency exclusion. IRC §108(a)(2)(C).
The IRS has revised Form 982 to allow for the principal residence exclusion. The IRS expected to begin accepting Form 982 filed electronically on March 3. Paper versions of updated Form 982 are available and currently being accepted by the IRS.