Tuesday, June 21, 2011

Mortgage Debt Forgiveness

We saw a home foreclosure reported this tax season.

You may remember that the Mortgage Relief Act allows taxpayers to exclude up to $2 million of mortgage debt forgiveness on their principal residence. This is an exception that the general rule that includes cancelled debt in income. The term of art is “qualified principal residence debt.” The key part here is “principal residence.” You can have several homes, but only one home can be your principal residence. A principal residence can be a house, a condominium, a cooperative, a mobile home or houseboat. I remember a fellow who docks his yacht off the coast of Jacksonville. I suppose he could consider his yacht his principal residence, if he and his wife lived there enough. It wouldn't be a bad life, as the yacht was around 100 feet long and had a professional crew. He was, needless to say, quite well-off.

Here is what doesn’t qualify: a vacation home, a second home, a business property or a rental property.

The debt itself must have been incurred to buy, construct or substantially improve that principal residence. Herein lays a possible trap. Say that you refinanced your house for $250,000 when its original mortgage was $180,000. You used the additional monies to … well, who knows what you did, but you did not fix-up the house. Maybe you sent a kid to college. If the house gets foreclosed and that debt cancelled, you may have a problem. Let’s say the debt is $250,000, to keep the discussion easy. Only $180,000 of that debt will qualify, as only $180,000 represents the purchase, construction or improvement (or refinancing of the same) of the principal residence. The remaining $70,000 ($250,000 – 180,000) represents income from cancelled debt. It may be that the $70,000 may be excludable under another provision (say insolvency), but it will not be excluded under the Mortgage Relief Act.

What I see as an unfortunate fact pattern is a saver who paid off, or paid down, his/her house and then runs up a second mortgage for unexpected debt, such as medical bills or unemployment. You can see that this mortgage would not have been incurred for the purchase, construction or improvement (or refinancing of the same) of a principal residence. There would be no relief for this person, at least under the Mortgage Relief Act.

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