Mortgage Debt Relief Forgiveness Act of 2007

Earlier this week the House of Representatives passed the Mortgage Debt Relief Forgiveness Act of 2007. The President is not expected to veto.

There are several tax reductions included in this bill. Two of these reductions are:

• A three year exclusion (ending 12/31/09) for mortgage debt forgiveness income on a principal residence, up to $2 million.

• Extension of the $500,000 exclusion on sales on principal residences to people whose spouses die within two years of the sale, if the spouses would have been qualified for the $500,000 exclusion at the time of the death.

I am always in favor of tax reductions, but as my previous post indicated sometimes tax reductions don’t have the effect the general public believes they do.

The first reduction is interesting. If a lender forgives a borrower of his debt, the amount that has been forgiven is treated as income which is taxable and reported on Form 1099-C. However, if a person is deemed to be insolvent no income from cancellation of debt is taxable. In the current market it has become increasingly common to see homes foreclosed or sold ‘short’ (i.e. sold for less than the debt owed). In those instances lenders become unsecured creditors and can either attempt to collect the money through other means or ‘forgive’ the debt. If a lender is willing to forgive the debt, it is usually an indication that the lender feels they will not collect any additional money because the borrower is probably insolvent. So this portion of the bill probably has no effect on tax revenues because only in exceptions is forgiven debt related to a principal residence taxable in the first place.

The second tax reduction really pulls at your heartstrings. Nobody wants to see widowed spouses pay extra taxes. Under current law, homeowners who file married jointly can exclude up to $500,000 of gain on the sale of principal residences ($250,000 for single taxpayers). Gain is calculated as the difference between sales price and basis (roughly original cost plus improvements made). I mentioned earlier that the median home value for the 3rd quarter 2007 was $220,000 which means half of all homeowners won’t have a $250,000 gain even if their home was given to them at no cost. So how many people does this provision affect? If we assume an appreciation rate of 3 times cost, only those in homes worth $375,000 would be affected (assuming basis of $125,000). But in order to have a gain of $250K on a $375K home one would probably have to own that home since before 1980 (based on national appreciation averages). The National Association of Realtors doesn’t make some of this data available to non-members, but suffice it to say that in order to benefit you would have to have an extremely valuable home (probably $1M+) and a low basis (probably bought in the 1970’s). Also remember that this provision only applies to principal residences not farmland or undeveloped land were oftentimes the real appreciation is seen.

So once again we see a tax reduction from Congress which I certainly favor. However, you can probably count on a couple of hands the number of people that will actually benefit.