After letting the world flounder for a year on what the Mortgage Forgiveness Debt Relief Act actually means, and how it intends to help taxpayers wade through the issues, the IRS has finally issued some insights. I don’t believe this is the last word on this issue, and, for reasons I discuss elsewhere on this site, I suspect that this is just the start of many problems to come. My crystal ball says that we won’t really understand the depth of this problem until 2013 or 2015 when the audits of taxpers from 2007 through 2010 start being conducted and wind through the courts.
NOTICE: This isn’t my post; It is a verbatim reproduction of the IRS’s FAQ on the Mortgage Forgiveness Debt Relief Act.
If you owe a debt to someone else and they cancel or forgive that debt, the amount of the canceled debt may be taxable.
The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.
This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.
The following are the most commonly asked questions and answers about The Mortgage Forgiveness Debt Relief Act and debt cancellation:
What is Cancellation of Debt?
If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.
Here’s a very simplified example. You borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you.
Is Cancellation of Debt income always taxable?
Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:
- Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
- Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
- Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
- Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.
- Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.
These exceptions are discussed in detail in Publication 4681.
What is the Mortgage Forgiveness Debt Relief Act of 2007?
The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007 (see News Release IR-2008-17). Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence.
What does exclusion of income mean?
Normally, debt that is forgiven or cancelled by a lender must be included as income on your tax return and is taxable. But the Mortgage Forgiveness Debt Relief Act allows you to exclude certain cancelled debt on your principal residence from income. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.
Does the Mortgage Forgiveness Debt Relief Act apply to all forgiven or cancelled debts?
No. The Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. This is known as qualified principal residence indebtedness. The maximum amount you can treat as qualified principal residence indebtedness is $2 million or $1 million if married filing
Does the Mortgage Forgiveness Debt Relief Act apply to debt incurred to refinance a home?
Debt used to refinance your home qualifies for this exclusion, but only to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified. For more information, including an example, see Publication 4681.
How long is the relief offered by the Mortgage Forgiveness Debt Relief Act in effect?
It applies to qualified principal residence indebtedness forgiven in calendar years 2007 through 2012.
Is there a limit on the amount of forgiven qualified principal residence indebtedness that can be excluded from income?
The maximum amount you can treat as qualified principal residence indebtedness is $2 million ($1 million if married filing separately for the tax year), at the time the loan was forgiven. If the balance was greater, see the instructions to Form 982 and the detailed example in Publication 4681.
If the forgiven debt is excluded from income, do I have to report it on my tax return?
Yes. The amount of debt forgiven must be reported on Form 982 and this form must be attached to your tax return.
Do I have to complete the entire Form 982?
No. Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Adjustment), is used for other purposes in addition to reporting the exclusion of forgiveness of qualified principal residence indebtedness. If you are using the form only to report the exclusion of forgiveness of qualified principal residence indebtedness as the result of foreclosure on your principal residence, you only need to complete lines 1e and 2. If you kept ownership of your home and modification of the terms of your mortgage resulted in the forgiveness of qualified principal residence indebtedness, complete lines 1e, 2, and 10b. Attach the Form 982 to your tax return.
Where can I get IRS Form 982?
If you use a computer to fill out your return, check your tax-preparation software. You can also download the form at IRS.gov, or call 1-800-829-3676. If you call to order, please allow 7-10 days for delivery.
How do I know or find out how much debt was forgiven?
Your lender should send a Form 1099-C, Cancellation of Debt, by February 2, 2009. The amount of debt forgiven or cancelled will be shown in box 2. If this debt is all qualified principal residence indebtedness, the amount shown in box 2 will generally be the amount that you enter on lines 2 and 10b, if applicable, on Form 982.
Can I exclude debt forgiven on my second home, credit card or car loans?
Not under this provision. Only cancelled debt used to buy, build or improve your principal residence or refinance debt incurred for those purposes qualifies for this exclusion. See Publication 4681 for further details.
If part of the forgiven debt doesn’t qualify for exclusion from income under this provision, is it possible that it may qualify for exclusion under a different provision?
Yes. The forgiven debt may qualify under the insolvency exclusion. Normally, you are not required to include forgiven debts in income to the extent that you are insolvent. You are insolvent when your total liabilities exceed your total assets. The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness. If you believe you qualify for any of these exceptions, see the instructions for Form 982. Publication 4681 discusses each of these exceptions and includes examples.
I lost money on the foreclosure of my home. Can I claim a loss on my tax return?
No. Losses from the sale or foreclosure of personal property are not deductible.
If I sold my home at a loss and the remaining loan is forgiven, does this constitute a cancellation of debt?
Yes. To the extent that a loan from a lender is not fully satisfied and a lender cancels the unsatisfied debt, you have cancellation of indebtedness income. If the amount forgiven or canceled is $600 or more, the lender must generally issue Form 1099-C, Cancellation of Debt, showing the amount of debt canceled. However, you may be able to exclude part or all of this income if the debt was qualified principal residence indebtedness, you were insolvent immediately before the discharge, or if the debt was canceled in a title 11 bankruptcy case. An exclusion is also available for the cancellation of certain nonbusiness debts of a qualified individual as a result of a disaster in a Midwestern disaster area. See Form 982 for details.
If the remaining balance owed on my mortgage loan that I was personally liable for was canceled after my foreclosure, may I still exclude the canceled debt from income under the qualified principal residence exclusion, even though I no longer own my residence?
Yes, as long as the canceled debt was qualified principal residence indebtedness. See Example 2 on page 13 of Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.
Will I receive notification of cancellation of debt from my lender?
Yes. Lenders are required to send Form 1099-C, Cancellation of Debt, when they cancel any debt of $600 or more. The amount cancelled will be in box 2 of the form.
What if I disagree with the amount in box 2 of IRS Form 982?
Contact your lender to work out any discrepancies and have the lender issue a corrected Form 1099-C.
How do I report the forgiveness of debt that is excluded from gross income?
(1) Check the appropriate box under line 1 on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) to indicate the type of discharge of indebtedness and enter the amount of the discharged debt excluded from gross income on line 2. Any remaining canceled debt must be included as income on your tax return.
(2) File Form 982 with your tax return.
My student loan was cancelled; will this result in taxable income?
In some cases, yes. Your student loan cancellation will not result in taxable income if you agreed to a loan provision requiring you to work in a certain profession for a specified period of time, and you fulfilled this obligation.
Are there other conditions I should know about to exclude the cancellation of student debt?
Yes, your student loan must have been made by:
(a) the federal government, or a state or local government or subdivision;
(b) a tax-exempt public benefit corporation which has control of a state, county or municipal hospital where the employees are considered public employees; or
(c) a school which has a program to encourage students to work in underserved occupations or areas, and has an agreement with one of the above to fund the program, under the direction of a governmental unit or a charitable or educational organization.
Can I exclude cancellation of credit card debt?
In some cases, yes. Nonbusiness credit card debt cancellation can be excluded from income if the cancellation occurred in a title 11 bankruptcy case, or to the extent you were insolvent just before the cancellation. See the examples in Publication 4681.
How do I know if I was insolvent?
You are insolvent when your total debts exceed the total fair market value of all of your assets. Assets include everything you own, e.g., your car, house, condominium, furniture, life insurance policies, stocks, other investments, or your pension and other retirement accounts.
How should I report the information and items needed to prove insolvency?
Use Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) to exclude canceled debt from income to the extent you were insolvent immediately before the cancellation. You were insolvent to the extent that your liabilities exceeded the fair market value of your assets immediately before the cancellation.
To claim this exclusion, you must attach Form 982 to your federal income tax return. Check box 1b on Form 982, and, on line 2, include the smaller of the amount of the debt canceled or the amount by which you were insolvent immediately prior to the cancellation. You must also reduce your tax attributes in Part II of Form 982.
My car was repossessed and I received a 1099-C; can I exclude this amount on my tax return?
Only if the cancellation happened in a title 11 bankruptcy case, or to the extent you were insolvent just before the cancellation. See Publication 4681 for examples.
Are there any publications I can read for more information?
(1) Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals) is new and addresses in a single document the tax consequences of cancellation of debt issues.
(2) See the IRS news release IR-2008-17 with additional questions and answers on IRS.gov.
I get a lot of questions about bankruptcy basics: What’s the difference between Chapters 7, 11 and 13: What is a discharge? What can I keep? What will I lose?
Here, without fanfare or embellishment, is how the federal government describes the process. All in all, I think it’s a pretty good presentation, though of course, it lacks the “inside baseball” reality from the trenches that you can get from an attorney who spends a lot of time in the Bankruptcy Court. For that, you’ll have to pick up a phone.
I do not claim authorship of the following: It is extracted verbatim from the Federal Court’s website, and the link to the original is here. I have omitted sections relating to Chapters 9 and 12 as they don’t apply to the vast majority of people. If you have been told that they might apply to you, then check the link above.
Over the coming weeks I will also reprint some of the specific information on Chapters 7 and 13.
Article I, Section 8, of the United States Constitution authorizes Congress to enact “uniform Laws on the subject of Bankruptcies.” Under this grant of authority, Congress enacted the “Bankruptcy Code” in 1978. The Bankruptcy Code, which is codified as title 11 of the United States Code, has been amended several times since its enactment. It is the uniform federal law that governs all bankruptcy cases.
The procedural aspects of the bankruptcy process are governed by the Federal Rules of Bankruptcy Procedure (often called the “Bankruptcy Rules”) and local rules of each bankruptcy court. The Bankruptcy Rules contain a set of official forms for use in bankruptcy cases. The Bankruptcy Code and Bankruptcy Rules (and local rules) set forth the formal legal procedures for dealing with the debt problems of individuals and businesses.
There is a bankruptcy court for each judicial district in the country. Each state has one or more districts. There are 90 bankruptcy districts across the country. The bankruptcy courts generally have their own clerk’s offices.
The court official with decision-making power over federal bankruptcy cases is the United States bankruptcy judge, a judicial officer of the United States district court. The bankruptcy judge may decide any matter connected with a bankruptcy case, such as eligibility to file or whether a debtor should receive a discharge of debts. Much of the bankruptcy process is administrative, however, and is conducted away from the courthouse. In cases under chapters 7, 12, or 13, and sometimes in chapter 11 cases, this administrative process is carried out by a trustee who is appointed to oversee the case.
A debtor’s involvement with the bankruptcy judge is usually very limited. A typical chapter 7 debtor will not appear in court and will not see the bankruptcy judge unless an objection is raised in the case. A chapter 13 debtor may only have to appear before the bankruptcy judge at a plan confirmation hearing. Usually, the only formal proceeding at which a debtor must appear is the meeting of creditors, which is usually held at the offices of the U.S. trustee. This meeting is informally called a “341 meeting” because section 341 of the Bankruptcy Code requires that the debtor attend this meeting so that creditors can question the debtor about debts and property.
A fundamental goal of the federal bankruptcy laws enacted by Congress is to give debtors a financial “fresh start” from burdensome debts. The Supreme Court made this point about the purpose of the bankruptcy law in a 1934 decision:
[I]t gives to the honest but unfortunate debtor…a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt.
Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934). This goal is accomplished through the bankruptcy discharge, which releases debtors from personal liability from specific debts and prohibits creditors from ever taking any action against the debtor to collect those debts. This publication describes the bankruptcy discharge in a question and answer format, discussing the timing of the discharge, the scope of the discharge (what debts are discharged and what debts are not discharged), objections to discharge, and revocation of the discharge. It also describes what a debtor can do if a creditor attempts to collect a discharged debt after the bankruptcy case is concluded.
Six basic types of bankruptcy cases are provided for under the Bankruptcy Code, each of which is discussed in this publication. The cases are traditionally given the names of the chapters that describe them.
Chapter 7, entitled Liquidation, contemplates an orderly, court-supervised procedure by which a trustee takes over the assets of the debtor’s estate, reduces them to cash, and makes distributions to creditors, subject to the debtor’s right to retain certain exempt property and the rights of secured creditors. Because there is usually little or no nonexempt property in most chapter 7 cases, there may not be an actual liquidation of the debtor’s assets. These cases are called “no-asset cases.” A creditor holding an unsecured claim will get a distribution from the bankruptcy estate only if the case is an asset case and the creditor files a proof of claim with the bankruptcy court. In most chapter 7 cases, if the debtor is an individual, he or she receives a discharge that releases him or her from personal liability for certain dischargeable debts. The debtor normally receives a discharge just a few months after the petition is filed. Amendments to the Bankruptcy Code enacted in to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 require the application of a “means test” to determine whether individual consumer debtors qualify for relief under chapter 7. If such a debtor’s income is in excess of certain thresholds, the debtor may not be eligible for chapter 7 relief.
Chapter 13, entitled Adjustment of Debts of an Individual With Regular Income, is designed for an individual debtor who has a regular source of income. Chapter 13 is often preferable to chapter 7 because it enables the debtor to keep a valuable asset, such as a house, and because it allows the debtor to propose a “plan” to repay creditors over time – usually three to five years. Chapter 13 is also used by consumer debtors who do not qualify for chapter 7 relief under the means test. At a confirmation hearing, the court either approves or disapproves the debtor’s repayment plan, depending on whether it meets the Bankruptcy Code’s requirements for confirmation. Chapter 13 is very different from chapter 7 since the chapter 13 debtor usually remains in possession of the property of the estate and makes payments to creditors, through the trustee, based on the debtor’s anticipated income over the life of the plan. Unlike chapter 7, the debtor does not receive an immediate discharge of debts. The debtor must complete the payments required under the plan before the discharge is received. The debtor is protected from lawsuits, garnishments, and other creditor actions while the plan is in effect. The discharge is also somewhat broader (i.e., more debts are eliminated) under chapter 13 than the discharge under chapter 7.
Chapter 11, entitled Reorganization, ordinarily is used by commercial enterprises that desire to continue operating a business and repay creditors concurrently through a court-approved plan of reorganization. The chapter 11 debtor usually has the exclusive right to file a plan of reorganization for the first 120 days after it files the case and must provide creditors with a disclosure statement containing information adequate to enable creditors to evaluate the plan. The court ultimately approves (confirms) or disapproves the plan of reorganization. Under the confirmed plan, the debtor can reduce its debts by repaying a portion of its obligations and discharging others. The debtor can also terminate burdensome contracts and leases, recover assets, and rescale its operations in order to return to profitability. Under chapter 11, the debtor normally goes through a period of consolidation and emerges with a reduced debt load and a reorganized business.
The bankruptcy process is complex and relies on legal concepts like the “automatic stay,” “discharge,” “exemptions,” and “assume.” Therefore, the final chapter of this publication is a glossary of Bankruptcy Terminology which explains, in layman’s terms, most of the legal concepts that apply in cases filed under the Bankruptcy Code.
There’s an old saying: Beware of Greeks bearing gifts. It refers to the Trojan horse that the Greek army used to trick its way into Troy during the Trojan War. It has come to refer to situations and people that hide fraud and trickery behind a friendly and perhaps even generous demeanor.
The hottest new business in California? One guess…. Mortgage modification. Everyone and their brother is now opening up “mortgage modification” companies. They appear friendly and eager to “help you save your home,” but be careful.
For instance, one I recently heard about is American Home Mortgage Servicing Company. This company is not licensed as a real estate broker by the California Department of Real Estate. (If you want to check whether the company that is pitching you to modify your mortgage is a licensed real estate broker, use the DRE license check tool here.) Therefore, it is not a licensed “mortgage broker” and is thus not legally licensed to modify mortgages. It is not a law firm. It is not a non-profit credit counselor. In fact, a little research reveals that it is nothing but a debt collector. An unlicensed debt collector phishing for people with financial difficulties, which it refer to as “customers.” (For reasons unknown, California doesn’t require debt collectors to be licensed any more. It does, however, require them to comply with the California Fair Debt Collection Practices Act.)
Do what I did. Call their toll free number. Once you get past the language preference, the first thing on the tape is: “American Home Mortgage Servicing Company is a debt collector and may record and/or monitor calls.” Then, follow the various links on their website as if you are looking to modify your mortgage. You will eventually wind up on a form that you need to fill out and return to them. Do not do this. This form is designed to solicit highly confidential financial information from you which will, in all likelihood, be used against you in the event that you default on your mortgage.
There is no need to provide this information at this stage of the conversation with anyone. (I’m a bankruptcy attorney subject to very strict rules of confidentiality. I usually have very good reasons to request this information from clients. Yet I never solicit this level of detail from prospective clients until they are an actual client and I have a rational and business-related reason for collecting this information.) How do I know this isn’t a bona fide form for dealing with a mortgage modification? Look at it. It doesn’t even ask who your lender is. How are they going to modify a loan or provide you with advice and an opinion on the criteria required to modify the loan if they don’t know who the lender is? (Lenders’ criteria for modification are not uniform, and a loan that one lender may modify may not qualify under another lender’s program.)
Here’s the fact: No one has authority to modify your mortgage except you and your mortgage lender. Anyone who claims to be able to assist you in modifying your mortgage but doesn’t ask who holds that mortgage right out of the chute is probably up to something very different. Fortunately, these people tell you: They are “debt collectors.” I wouldn’t give them the name of my dog without a written disclosure of who they represent, what they are actually authorized to do and a written representation from them as to what exactly is going to be done with the information I provide them. I suspect that if you call them and make this demand as a precondition to your giving them any confidential financial information, they will hang up on you.
Who are these people? Are they licensed? Are they supposed to be? Who’s regulating these guys?
In short, no one. It’s the Wild Wild West. The California Department of Real Estate is supposed be on it, but in practical reality, it looks more like substitute teacher day in 5th Grade, erasers flying, tongues wagging, the whole works. And who can blame the CDRE? They’re overwhelmed. So it will fall on the consumer. If you try to do this without counsel, make sure that the person you’re dealing with knows what she is doing and that you’re protected.
Here are the rules, at least regarding licensing:
First, in order to function as a “mortgage modification company” in California the company must first be licensed as a “real estate broker” by the California Department of Real Estate. (California does not have a separate licensing category for “mortgage brokers” nor for “mortgage modifiers.”) Modifying a mortgage is essentially the functional equivalent of originating a mortgage, so the same licensing rules prevail. (Here’s an interesting opportunity to get a fly-on-the-wall ear to brokers talking to each other about this topic.)
Next, in order to collect any fee in advance for “mortgage modification” services, the entity must be licensed by the DRE and must submit its contract for services for approval to the DRE. So if someone tells you they’re a “mortgage modifier” and wants you to pay them for providing those services, first demand their DRE brokers’ license number and then check the DRE website to see if their contract has been approved yet by the DRE. If it hasn’t, then tell them you’ll pay them if and when they get a result for you.
[Update: Effective July 1, 2009, it is unlawful for a foreclosure consultant, as defined in Civil Code Section 2945.1 to engage in the foreclosure consultant business unless it has registered with the Attorney General’s Office at: http://www.ag.ca.gov/register.php. All foreclosure consultants operating in California must post a $100,000 bond and register with Attorney General’s Office by July 1, 2009. There is list of companies whose agreement has been approved. It’s very short. You can find it on this rather hard to find site called California Foreclosure Prevention Act. There is also a list of companies that have not been approved by the Attorney General, although that strikes me as sort of foolish. Given that scam artists work pretty hard to cut a low profile, its a bit like saying “raise your hand if you’re not here.”]
American Home Mortgage Servicing is not on that list. American Home Mortgage Servicing is also not a licensed real estate broker in the State of California. In fact, American Home Mortgage Servicing does not appear to be licensed to do anything more complicated than exist in the State of California. And it’s a Delaware corporation so it’s not even domiciled here. (Debt collectors no longer need to be licensed in California.)
(Here’s a link to the California Attorney General’s recent online posting about how to avoid being ripped off by foreclosure rescue scams. And here’s another article/consumer warning by the DRE about scams offering to “cut your home payments in half.”)
There is a growing number of unscrupulous people out there right now looking to take advantage of people who are in financial extremis. There are also tons of folks who, while maybe not slimeballs, are woefully unqualified to “modify” anything more complicated than a typo on a spelling test.
Current statistics suggest that only 5% of the people who attempt to modify their mortgages are actually succeeding right now, and of those? More than 50% re-default in the first 6 months! I’m not going to blame all of that on slimeballs and idiots, but I can’t think of any argument that suggests that the presence of opportunistic and unscrupulous slimeballs and idiots posing as “mortgage modifiers” is helping matters.
But there are also a lot of good, qualified and experienced people who want to help, who charge a reasonable fee and who know what they’re doing. (And I absolutely guarantee you that they don’t refer to themselves on their voicemail as “debt collectors.”) Some are mortgage brokers, some are attorneys, some are credit counselors. None are debt collectors. Look for non-profit credit counselors as a start.
I’m not suggesting that everyone who wants to investigate mortgage modification hire an attorney. But at least do a little homework and make sure the person or company you hire is qualified and licensed. If they disclose that they are “debt collectors” run the other way. Such people have nothing of value to offer you.