New tax breaks a relief to homeowners
There are three main existing exemptions.
First, in some states, such as California, all purchase-money home loans are required to be "nonrecourse" debt, which means the lender can't pursue the borrower for additional money that's still owed after the property is sold.
A "recourse" loan, on the other hand, means the borrower is personally responsible for the debt and must pay the difference if the sale of the property doesn't pay off the balance that's owed to the lender.
"In Texas, for example, which is one of the recourse states, they have a different attitude about collecting loans. They basically follow you around until they get the money back. They still do short sales and they accept discounts to avoid having to chase someone, but they bargain from a different perspective," Watkins says.
The distinction is crucial because the lender can pursue the debt on a recourse loan even if a foreclosure or short sale occurred; but without recourse, there is no debt to be forgiven and thus no ordinary-income tax liability for the borrower. The new tax break means borrowers who have a recourse loan also can avoid the tax liability.
Second, borrowers who
are insolvent are relieved from ordinary income tax liability on
forgiveness of debt to the degree of their negative net worth, Watkins
explained. For example, an individual whose assets totaled $400,000
and whose debts totaled $500,000 would have a negative net worth
of $100,000. Forgiveness of debt on a principal residence acquisition
loan up to that amount wouldn't be subject to federal income tax.
Third, forgiveness of
debt tax liability is wiped out if the taxpayer files for bankruptcy.
That's not a free ride, because bankruptcy is subject to its own costs,
hassles and credit implications.
A capital gain that resulted from a foreclosure,
short sale or deed in lieu of foreclosure may still be subject to
taxation. This situation is rare, since homeowners who experience
these events typically owe more than their home is worth and any
capital gain might be subject to a separate exclusion.
"Even though you have forgiveness of debt (excluded)
as ordinary income, if you do a short sale or foreclosure, that
money would be considered part of the proceeds from the sale of
the property, so you could theoretically still have some capital
gain on a short sale or foreclosure without going into bankruptcy
or being insolvent," Roth says.
Mortgage insurance deduction extended
The second tax break concerns mortgage insurance, which is paid for by the borrower, but protects the lender if the borrower defaults on the loan.
The new law extends a one-year deduction of mortgage
insurance premiums that was effective in 2007 for three more years,
2008, 2009 and 2010. That time frame means the deduction is allowable
only for mortgage insurance on loans that were originated after
Dec. 31, 2006, and before Jan. 1, 2011, unless the tax break is
further extended in the future.
The full deduction is available only to taxpayers whose adjusted gross income is less than $100,000. A partial deduction is allowed for adjusted gross incomes up to $109,000. The deduction is worth $350 for the average taxpayer, according to Mortgage Insurance Companies of America, an industry association.