Throughout most parts of the country, homeowners who unloaded their dwellings have reason to celebrate. They have benefitted from surges in housing values, particularly since the onset of the pandemic in early 2020.
Surges, though, provide only cold comfort for wannabe sellers who owe more on their mortgages than their places are worth, owners known colloquially as being upside down or under water.
Fortunately for upside-downers, their plight hasn’t gone unnoticed by our lawmakers, who crafted carefully composed legislation that benefits many of them, though doing absolutely nothing for others.
I’m devoting several columns that show accountants and other tax professionals how to help beleaguered borrowers whose mortgages are foreclosed or who engage in short sales. What follows are reminders on how the IRS interprets the rules and ways for borrowers to trim their taxes.
The basics. Internal Revenue Code Section 61(a) (12) generally requires debtors to report all forgiven debts on their 1040 forms, the same as they have to declare income from sources like salaries or investments. They also are dinged for taxes at the rates imposed on ordinary income from sources like pensions and distributions from individual retirement accounts and other kinds of tax-deferred arrangements.
Some forgiven debts sidestep taxes. Code Section 108 specifies several carefully hedged exceptions. One of them authorizes exclusions from income for individuals who’ve had mortgage debts forgiven or cancelled in mortgage meltdowns, transactions that realtors refer to as “mods,” short for loan modifications, foreclosures, deeds in lieu of foreclosure and short sales.
Loan modifications or restructurings: These workout deals ease normally reliable borrowers through rough patches. Lending companies typically lower interest rates or stretch out the payment terms, though many outfits whose earnings are boosted by late fees are averse to helping strapped borrowers.
Foreclosures: Usually, lenders lose lots of lucre on foreclosed dwellings because they incur substantial costs to maintain and then sell such properties––often at significant discounts. Among other things, lenders who use real estate brokers will have to pay commissions when the properties sell. Foreclosures typically net lenders only about 60 cents on the dollar.
Deeds in lieu of foreclosure: Defaulting borrowers agree to voluntarily transfer titles to property to lenders, who then waive their right to sue for amounts still owed. But lenders might require borrowers to try to sell their houses.
Short sales: They occur when an owner obtains the lender’s approval to sell for a net price (gross sales price minus legal fees, broker’s commission and other costs) that’s insufficient to cover all of the outstanding debt.
Debt forgiveness relief. Lawmakers first allowed special relief for debts eliminated during 2007, 2008 and 2009 (the Mortgage Cancellation Tax Relief Act of 2007). Fast forward through several exclusion renewals, most recently in the Consolidated Appropriations Act of 2021.
The 2021 legislation authorized the latest renewal through January 1, 2026, of the QPRI, short for Qualified Principal Residence Indebtedness. The exclusion also applies to debts forgiven pursuant to written agreements entered into before January 1, 2026. This holds true even when an actual discharge happens later.
What happens after the exclusion expires at the start of 2026, which just happens to be an election year? Congress almost always renews “temporary” tax breaks, especially when they benefit beleaguered homeowners.
Exclusion amounts. There are ceilings on the amounts forgiven as part of foreclosures or short sales. As of December 31, 2020, they’re as much as $750,000 for married couples filing jointly ($375,000 for single persons and married couples filing separately). Before December 31, 2020, the amounts were capped at $2 million and $1 million. For 2021 and subsequent years, forgiveness in excess of $750,000 (or $375,000) remains taxable.
Which exclusions pass muster and which don’t? For QPRI, or qualified principal residence indebtedness, purposes, an owner I’ll call Hester has to satisfy two requirements in order to exclude (sidestep) taxes.
First, the security for Hester’s mortgage must be her principal residence, meaning the place she ordinarily lives most of the year; the IRS also calls it her “primary residence.” Second, she must have incurred the debt to buy, build, or substantially improve that principal residence.
Also, the IRS prohibits relief when she obtains home equity loans or refinances, except to the extent that she used the proceeds to make improvements. Fine print also prohibits relief if lenders forgive debts on vacation homes and other second homes or rental properties.
A qualifying primary residence. Whether a property qualifies as a principal residence depends on “all the circumstances” of each case. When, for example, Hester resides at more than one property, the IRS treats the property that she uses the majority of the time during the year as her principal residence for that year.
It takes other factors into account. They include: her place of employment; the principal place her family lives; the mailing address she uses on her tax returns, driver’s license, automobile registration and insurance, voter registration card, and bills and correspondence; and locations of religious organizations and recreational clubs that she’s affiliated with.
While the IRS cautions that Hester can have only one main home at any one time, it’s indifferent to the location of her principal residence. It’s okay for the locale to be a county other than the United States.
QPRI. Section 108 allows an exclusion only for acquisition indebtedness. As noted earlier, this means mortgages taken out by owners to buy, build, or substantially improve their principal residences or main homes. And the residences serve as securities for the debts.
Section 108 also approves a limited exclusion for debt reduced through mortgage restructuring, and for debt used to refinance QPRI. Here, there’s relief only up to the amount of the old mortgage principal, just before the refinancing.
Another constraint on the exclusion: It doesn’t help homeowners who take advantage of surges in real estate prices to do “cash-out” refinancing, in which they didn’t use the funds for renovations of their primary residences. Instead, they used the funds to pay off credit card debts, tuition charges, medical expenses, or certain other expenditures.
This last category of prohibited outlays includes basic repairs that keep a home in good condition, but don’t add to its value, prolong its life, or adapt it to new uses. For instance, repainting a house, fixing gutters or floors, repairing leaks or plastering, or replacing broken window panes.
Let’s say that Hester purchased a residence for $315,000, making a down payment of $15,000 and taking out a $300,000 mortgage on which she was personally liable and which was secured by the residence. The following year, Hester took out a second mortgage loan of $50,000 that she used to add a garage to her house.
When the home’s market value was $430,000 and the outstanding principal of her first and second mortgage loans was $325,000, Hester refinanced the two loans into one loan of $400,000. She used the additional $75,000 debt (the amount by which the $400,000 new mortgage loan exceeded the $325,000 outstanding principal balances of both loans immediately before the refinancing) to pay off personal credit cards and to pay college tuition for her daughter.
For exclusion purposes, Hester’ post-financing QPRI is just $325,000. Why? Because the $400,000 qualifies as QPRI only to the extent it doesn’t exceed the $325,000 refinanced debt.
What’s next. Part two is going to discuss other aspects of exclusions for debts forgiven or cancelled in foreclosures or short sales.
