Many homeowners can claim tax-free mortgage workouts on newly-revised Form 982

IR 2008-17, Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment)

The IRS has announced that homeowners whose mortgage debt was partly or entirely forgiven during 2007 may be able to claim tax relief under the Mortgage Forgiveness Debt Relief Act of 2007 (Mortgage Relief Act, P.L. 110-142) by filling out newly-revised Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), and attaching it to their 2007 returns.

Due to the late-December enactment of the Mortgage Act, reporting procedures had not previously been incorporated into tax-preparation software or IRS forms.

Background. The Mortgage Relief Act, effective for indebtedness discharged on or after Jan. 1, 2007 and before Jan. 1, 2010, generally allows taxpayers to exclude up to $2 million of mortgage debt forgiveness on their principal residence. Specifically, under the Mortgage Relief Act, gross income doesn't include any discharge of qualified principal residence indebtedness. (Code Sec. 108(a)(1)(E)) Qualified principal residence indebtedness is acquisition indebtedness under Code Sec. 163(h)(3)(B) with respect to the taxpayers's principal residence, but with a $2 million limit ($1 million for married individuals filing separately). (Code Sec. 108(h)(2)) “Principal residence” has the same meaning as under the homesale exclusion rules of Code Sec. 121. (Code Sec. 108(h)(5)) Acquisition indebtedness of a principal residence is indebtedness incurred in the acquisition, construction, or substantial improvement of an individual's principal residence that is secured by the residence. It includes refinancing of debt to the extent the amount of the refinancing doesn't exceed the amount of the refinanced indebtedness. (Joint Committee on Taxation JCX-86-07)

The basis of the taxpayer's principal residence is reduced by the excluded amount, but not below zero. (Code Sec. 108(h)(1))

If any loan is discharged, in whole or in part, and only part of the loan is qualified principal residence indebtedness, the mortgage forgiveness exclusion applies only to so much of the amount discharged as exceeds the amount of the loan (as determined immediately before the discharge) which is not qualified principal residence indebtedness. (Code Sec. 108(h)(4))

The exclusion doesn't apply to a loan 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 taxpayer's financial condition. The exclusion also doesn't apply to a taxpayer in a Title 11 bankruptcy. (Code Sec. 108(h)(3)) An insolvent taxpayer (other than one in a Title 11 bankruptcy) can elect to have the mortgage forgiveness exclusion not apply and can instead rely on the Code Sec. 108(a)(1)(B) exclusion for insolvent taxpayers. (Code Sec. 108(a)(2))

Observation: Gain on a home sale may be partially or completely protected by the exclusion under Code Sec. 121 — even if that provision's 2-out-of-5-year ownership and use rule is not met — if the sale is made due to a change in employment, health, or “unforeseen circumstances.” Under Reg. § 1.121-3, the latter includes safe harbor events such as an involuntary conversion, job loss, and events identified by IRS as “unforeseen circumstances.”

Updated Form 982 is now available. In IR 2008-17, IRS alerts taxpayers that due to the late-December enactment of the Mortgage Relief Act, the reporting procedures for the law change weren't incorporated into tax-preparation software or IRS forms. As a result, people using tax software should check with their provider for updates that include Form 982 as revised to reflect the Mortgage Relief Act. Similarly, IRS is now updating its systems and expects to begin accepting electronically-filed returns that include Form 982 by March 3. The paper Form 982 is now being accepted, but IRS reminds affected taxpayers to consider filing electronically to reduce errors and speeds refunds.

In most cases, IRS says eligible homeowners only need to fill out a few lines on Form 982. Specifically, a taxpayer must complete: (a) line 1e, Discharge of qualified principal residence indebtedness; (b) line 2, Total amount of discharged indebtedness excluded from gross income; and (c) line 10b, [Amount] [a]pplied to reduce the basis of your principal residence.

IRS reminds taxpayers that under the Mortgage Relief Act, which applies to debt forgiven in 2007, 2008 or 2009, the debt must have been used to buy, build or substantially improve the taxpayer's principal residence and must have been secured by that residence. If the amount of a taxpayer's original mortgage is more than the cost of his principal residence plus the cost of any substantial improvements, only the debt that is not more than the cost of his principal residence plus improvements is qualified principal residence indebtedness. Debt used to refinance qualifying debt is also eligible for the exclusion, but only up to the amount of the old mortgage principal, just before the refinancing.

IRS notes that debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, may qualify for this relief. But, debt forgiven on second homes, rental property, business property, credit cards or car loans doesn't qualify for this tax-relief. In some cases, however, other kinds of tax relief (e.g., based on insolvency) may be available.

Ordering rules. An example in the instructions to Form 982 explains how to report forgiven debt where only a part of a loan is qualified principal residence indebtedness.

Illustration: Bob's principal residence is secured by a debt of $1 million, of which $800,000 is qualified principal residence indebtedness. If Bob's residence is sold for $700,000 and $300,000 of debt is discharged, only $100,000 of the debt discharged may be excluded ($300,000 discharged − $200,000 of nonqualified debt). The remaining $200,000 of nonqualified debt may qualify in whole or in part for one of the other exclusions (e.g., the insolvency exclusion).

The instructions to Form 982 caution that if the discharge occurs in a Title 11 bankruptcy case, a taxpayer can't treat it as a discharge of qualified principal residence indebtedness (i.e., by checking box 1e). Instead, the taxpayer must complete the form following the instructions for a nonbusiness debt (i.e., by checking box 1a). If a taxpayer is insolvent (and not in a Title 11 case), instead of treating it as a discharge of qualified principal residence indebtedness, he can elect to follow the insolvency rules (by checking box 1b) and complete the form following the instructions for a nonbusiness debt.

Lender's statement to borrower. For debt cancelled in 2007, lenders are required to provide by Jan. 31, 2008 a year-end statement (Form 1099-C, Cancellation of Debt) to borrowers whose debt was reduced or eliminated. This form must show the amount of debt forgiven and the fair market value of any property given up through foreclosure. IRS urges borrowers to review the Form 1099-C carefully and notify the lender immediately if any of the information shown on it is incorrect. IRS cautions that borrowers should pay particular attention to the amount of debt forgiven (Box 2) and the fair market value (FMV) listed for their home (Box 7).

Observation: Determining exactly what the FMV of the property is may not be an easy task. If the taxpayer surrenders his property to the bank in exchange for cancellation of debt in a foreclosure sale, the FMV normally will be the sale price. However, the winning bid at a foreclosure auction may not necessarily reflect the home's true value in some cases. For example, the bank may buy the property for a nominal sum and then resell it at a favorable price. Additionally, if the transfer is in lieu of foreclosure and the bank sells the home shortly thereafter, the taxpayer may wish to verify the actual selling price of the property. In some cases, taxpayers may not agree with the information on a Form 1099-C, and may have trouble convincing the lender to issue a corrected form. The best course of action (if the taxpayer can afford it) may be to have the property valued by an independent appraiser.