Issue:

What are the income tax consequences of 1.) modifying my mortgage; 2.)  signing a deed in lieu in satisfaction of a mortgage; or, 3.) obtaining a waiver of deficiency with respect to my mortgage?

 Applicable Law:

The general rule is that any amounts forgiven by a creditor results in Cancellation of Indebtedness Income to you, the debtor. 26 U.S.C. §108 (2010).  In some situations, this general rule is triggered when you modify your mortgage, whether the bank is forgiving a portion of the principal or reducing the interest rate on your note.  As a result, you must include the amounts being forgiven as gross income in the year that the debt is forgiven.  Creditors who cancel any debt in the sum of $600.00 or more must file a 1099-C with the Internal Revenue Service and provide you with a copy of the same stating what amounts you must include in your gross income for the year.  If you have modified your mortgage or obtained a waiver of deficiency, then you should receive a 1099C on or before January 15 of the following year.  If you do not receive a 1099C by February 1, you should contact the lender to determine the status of your 1099C.

There are a few exceptions to the general rule that the amount forgiven must be included in your gross income.  First, if you filed for bankruptcy or were insolvent at the time the debt is cancelled, then you may be able to exclude a portion of the debt. 26 U.S.C. §108(a)(1)(A) and (B) (2010).  Second, the Mortgage Debt Relief Act of 2007 [“MDRA”] added another exception for the forgiveness of debt relating to a “qualified principal residence.” 26 U.S.C. §108(a)(1)(E) (2010).    Since most of our clients seek relief under the MDRA, this memo addresses only the application of the MDRA on cancelled debt.  Accordingly, please seek the advice of counsel if you filed bankruptcy or were insolvent in the year that the mortgage was forgiven or modified.

Under the MDRA, you can exclude from gross income the cancellation of a debt that was incurred to purchase, build, or improve your “principal residence,” if the debt was secured by the residence.  26 U.S.C. §108(h)(2) and §163(h)(3)(B) (2010).  This exclusion is capped at $2 million ($1 million if married filing separately).  26 U.S.C. §108(h)(2).  This means that if a lender forgives a $200,000 deficiency on a mortgage that was used to purchase your primary residence and issues a 1099C for $200,000, then you can exclude that amount from your gross income.  Please be advised that this exception applies to any debt that is discharged before January 1, 2013.  Accordingly, if the bank approves the modification or release of deficiency after January 1, 2013, then you will have to report any amounts forgiven as income on your tax return for 2013 unless the federal government grants another extension of time.

The determination of whether the property qualifies as your “principal residence” is based on the facts and circumstances of each case.  26 CFR §1.121-1(b)(1) and (2) (2010).  Factors taken into consideration include, but are not limited to, the following: your place of employment; the principal place of abode of your family; the address listed on your license, tax returns, car registration, and voter registration card; your mailing address for correspondence and bills; location of your banks; and, the location of any religious organizations and recreational club with which you are affiliated.  26 CFR §1.121-1(b)(2) (2010).

There is a limitation on the availability of the MDRA exclusion.  Specifically, the discharge of the debt must be directly related to the decline in value of the residence or your financial condition.  26 U.S.C. §108(h)(3) (2010).  In addition, there are other limitations on the amounts that can be excluded if only a part of the cancelled debt qualifies as principal residence indebtedness.  §26 U.S.C. §108(h)(4) (2010).  For instance, if you modify or obtain a release relating to a second mortgage on your residence, but not all the proceeds from the second mortgage were used to purchase or improve your residence, then only a portion, if any, of the amounts forgiven can be excluded.  This limitation greatly impacts those clients who took out a second mortgage for reasons other than home improvement, such as to finance a business venture, college tuition, and/or family vacations.  This memorandum does not address all of the limitations imposed, and the advice of legal counsel should be sought prior to negotiating a modification or release of mortgage.

Also, there is an important consequence resulting from the exclusion of the cancelled debt. Any amounts excluded from your gross income under §108(a)(1)(E) are applied to reduce your basis in your residence.  26 U.S.C. §108(h)(1) (2010).  This reduction in your basis will increase the amount of gain, if any, that will have to recognize upon the sale of your residence.  There are provisions that allow for you to exclude from income a portion of, if not all of, the gain relating to the sale of your principal residence; however, the requirements for this exclusion are outside of the scope of this memorandum.  26 U.S.C. §121 (2010).

Even though the cancelled debt is excluded from your gross income for the year, because a Form 1099 is being issued, you must still report the amount provided on the 1099C on a Form 982 to be filed with your tax return for the year in which the debt is cancelled.

[author] [author_image timthumb=’on’]http://www.bretjonespa.com/main/wp-content/uploads/2012/06/BJones-90-86-square.jpg[/author_image] [author_info]An intensely critical thinker, Attorney Cazobon focuses on the facts and the application of the law to the acts, rather than through social needs or media. Attorney Cazobon is one of the significant reasons that Bret Jones, P.A. rarely does “basic” estate plans but rather customized and creative means to accomplish a client’s personal goals whether those be short-term, long-term, tax-related, or part of an overall business or life plan.[/author_info] [/author]