Sub-prime Mortgage Debt Relief and the IRS

By Cameron Street

The downturn the housing market is currently experiencing was both predictable and inevitable. Speculative buying spread throughout many areas of the country fueled by the unprecedented availability of loans to borrowers in the sub-prime credit category as well as other types of high risk adjustable rate loan products. Wall Street and its investors in these loan products, called mortgage-backed securities and the now notorious collateral debts obligation (or CDOs) sparked this combustible cycle with their insatiable appetite for yield and their willingness to take on imprudent levels of uncharted risk. Sadly many of the borrowers who acquired their homes through either sub-prime or the high risk ever-rising-property-value dependent adjustable rate loan products are now faced with the fact that the party has ended and they are going to be left with a huge debt hangover. Foreclosure is on the horizon for a high percentage of these borrowers but tragically their problems will not end there. As if losing ones home and the resulting devastating blow to ones credit weren't enough, many homeowners may not be aware that debt cancellation (also called forgiveness) by your lender will result in a 1099 being generated with your name on it in the amount of the unpaid debt. Essentially, the IRS is going to tax you on the amount of debt cancelled or forgiven by a lender as if it were ordinary income you received within that year.

The debt you believed to be wiped out or "forgiven" by your lender is actually treated as income to you. For example if you were to borrow $250,000 from a lender to purchase your home and then you were to pay back only $50,000 and proceed to go into default on your payments after that, the lender will write off $200,000 in remaining outstanding debt which was owed by you and you would then receive a Form 1099-C (Cancellation of Debt) upon which ordinary income tax would be due. If interest on the mortgage is also forgiven, that could appear on the 1099-C as well depending upon whether or not the interest was tax deductible. Whenever personal debt is cancelled by any type of lender or creditor, the amount that is cancelled or forgiven is treated as ordinary income by the IRS unless the borrower in question is declared bankrupt or insolvent. A borrower would be deemed to be insolvent if after reducing the amount cancelled or forgiven debt from their original liabilities, the total outstanding debt still exceeds the borrower's total assets. You would claim relief of this kind on IRS Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) if applicable in your particular case.

However fortunately help may be on the way, The Mortgage Cancellation Tax Relief Act of 2007 (HR 1876) would attempt to expand protection from the IRS by shielding those borrowers who are not bankrupt or insolvent. The bill would in essence amend the tax code to exclude debt forgiveness on mortgages secured by a primary residence from being treated as ordinary income. It is interesting to note that this change or amendment would simply be a return to IRS policy prior to the last infamous lending debacle, also know as the Savings and Loan Crisis. This legislation could also assist the expanding number of homeowners who are on the brink of foreclosure and are considering either a "short sale" or a "deed-in-lieu of foreclosure". A short sale involves selling your home for less than the amount of the mortgage(s) secured against it and a deed-in-lieu of foreclosure is simply an agreement between you and your lender that will permit you to turn over your deed or ownership of the property to your lender rather than proceeding with the foreclosure process, both aforementioned events would currently trigger a 1099-C from your lender. The bill is currently in committee where it will be reviewed prior to proceeding onto a vote by Congress. If passed this could result in easing the nation's sub-prime mortgage debt hangover to the tune of $2 billion in debt relief, a welcome tonic indeed.

Always consult with your tax or financial advisor regarding your own individual circumstances before proceeding with any plan which may have a dramatic impact on your personal finances.