Options for Distressed Homeowners: the Mortgage Forgiveness Debt Relief Act

Relief from mortgage debt doesn’t have to result in heavy tax burdens

In the wake of the 2007 housing market crash, Congress enacted the Mortgage Forgiveness Debt Relief Act of 2007 (the “Act”). Central to the Act was a provision that, subject to certain conditions, temporarily excluded debt forgiveness from a mortgage lender on a borrower’s primary residence from taxable income.

Under the Internal Revenue Code (the “Code”), discharged debt—for whatever reason—is defined as “gross income” and is considered taxable. See 26 U.S.C. § 61(a)(12). Prior to the Act, Congress had provided some very limited exceptions to this general rule. By ratifying the Act, Congress eased the burden on distressed homeowners by adding one more exemption.

The Act temporarily modified the Code to provide an exemption on discharged debt on mortgage loans on the debtor’s primary residence. The exemption did not apply to second homes, investment properties, or commercial property. Likewise, car loans, credit card debt, and all other types of unsecured debt were not eligible for the exemption.

The new exemption was significant for distressed homeowners because underwater mortgage loans usually result in loan modification, foreclosure, deed in lieu of foreclosure, or short sale. In the case of short sales, loan modifications, and deeds in lieu, mortgage lenders normally agree to forgive some or all of the debt above the market value of the underwater home. In a foreclosure, lenders often forgive the debt by declining to sue the borrower for the deficiency. In Arizona, foreclosure deficiencies on most residential homes are discharged by operation of law. See A.R.S. §§ 33-729(A) and 814(G). Under the Act, debt discharged under these circumstances was untaxable.

This was good news for distressed homeowners because they could relinquish their underwater homes through foreclosure, short sale, or deed in lieu of foreclosure, or modify their loan and not incur any resulting tax liability.

Extension of the MFDRA

The Act was originally set to expire at the end of 2014, but Congress extended the Act through the 2016 tax year. As of today, the Act is expired and debt forgiven on primary residence mortgage loans will be taxable income for tax year 2017. However, legislation to extend the Act through tax year 2018 has been introduced.^[1] Whether this proposed extension will succeed in becoming law is difficult to predict. So, homeowners considering a loan modification, short sale, or deed in lieu should consult an attorney who can help weigh their options and determine if they qualify for another exemption under the Code.

If you need assistance with an underwater mortgage or have questions about short sales, foreclosures, deeds in lieu, or loan modifications, the experienced attorneys at Lancer Law can provide you with the guidance you need to make an informed decision. To schedule a consult, call  (520) 369-4274 or email [email protected].

^[1] See H.R. 2543 – Mortgage Forgiveness Tax Relief Act of 2017, available at  https://www.congress.gov/bill/115th-congress/house-bill/2543?q=%7B%22search%22%3A%5B%22mortgage%22%5D%7D&r=8.