Homeowners whose mortgage lenders allow them to walk away from their debt got a big break from the new Tax Increase Prevention Actjust passed by Congress. Under the old law, debt forgiveness was considered taxable income in many cases - pretty painful stuff when the reason you couldn’t pay your mortgage was because you didn’t have the cash.

By Helen Huntley, Times Personal Finance Editor
Published January 6, 2008

Homeowners whose mortgage lenders allow them to walk away from their debt got a big break from the new Tax Increase Prevention Actjust passed by Congress. Under the old law, debt forgiveness was considered taxable income in many cases - pretty painful stuff when the reason you couldn’t pay your mortgage was because you didn’t have the cash.

Now forgiveness of debt or resetting of terms will not be taxable if the debt was taken on to buy, build or substantially improve your primary residence. A cashout refinancing is not eligible to the extent that it exceeds the original mortgage amount.

“This is much needed,” said Scott Stamatakis, an owner of Unity One, a Tampa real estate company that specializes in “short sales,” deals in which desperate homeowners sell property for less than what they owe on the mortgages to short circuit foreclosure proceedings. For the deal to close, the lender has to agree to accept the buyer’s bid as payment for the mortgage. These situations have become more common as real estate prices have dropped.

“It’s almost an insult for a person to be in a financial bind such as foreclosure and then, when it’s over, not only did they lose the house but there’s an extra $50,000 to $100,000 income they have to report. It’s like being kicked when you’re down.”

Stamatakis said lenders typically have written off the remaining debt rather than chasing the borrower for the deficiency. The result was taxable income for borrowers unless they could show they were insolvent at the time. But if they had a positive net worth (what they owned was worth more than what they owed), they were out of luck.

The law also will benefit people who stay in their homes under “workout” arrangements in which lenders agree to change the mortgage’s terms to make them more favorable to the borrower. The Bush administration’s plan for freezing the rates on certain adjustable rate mortgages is one example. If the law had not changed, the deals would produce taxable income.

The break for besieged homeowners is probably the most overlooked piece of good news in the latest tax bill. All the attention has been focused on the law’s extension of AMT (alternative minimum tax) exemptions. Basically that means if you didn’t have to pay the AMT last year, you probably won’t this year either.

The bad news about the tax bill is that the AMT fix could mean a delay in your tax refund even if you aren’t an AMT filer. The AMT rules are so convoluted that changing them required changes to a dozen tax forms, which in turn require extensive reprogramming of IRS computer systems.

Ironically, the work related to the actual alternative minimum tax form (Form 6251) has been completed. However, the IRS doesn’t expect to be finished with work related to several other forms until Feb. 11. That means you can’t file before then if your return includes education credits (Form 8863), residential energy credits (Form 5695), mortgage interest credits (Form 8396) or the 1040A form for child and dependent care expenses (Schedule 2).

If you do your own tax return, it will be very important that you update your software or get the revised version of paper forms (available at www.irs.gov) before filing. The packages being mailed out to taxpayers include the earlier versions of the forms.

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Two other items in the tax bill will affect certain homeowners:

- The deduction for mortgage insurance premiums has been extended. It applies to mortgages taken out after Dec. 31, 2006.

- Widows and widowers can get a $500,000 exclusion of capital gains on the sale of a home for up to two years after the death of a spouse. After that, the $250,000 exclusion for single taxpayers will apply.

How mortgage debt forgiveness will work

Harry Homeowner owes $200,000 on his mortgage. His lender forecloses and sells the house for $150,000.

Before 2007: The $50,000 difference was taxable income to Harry.

In 2007, 2008 and 2009: There is no taxable income to Harry.

Take your time filing

It will be at least a month before the IRS can accept returns with any of these forms:

- Form 8863 education credits

- Form 5695 residential energy credits

- Form 8396 mortgage interest credit

- Schedule 2, Form 1040A child and dependent care expenses

[Last modified January 4, 2008, 20:54:31]