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New tax breaks a relief to homeowners

Homeowners found three attractive tax breaks among their holiday presents, thanks to the federal Mortgage Forgiveness Debt Relief Act of 2007, which was enacted in December.

Forgiven debt may be free from income tax
The first tax break concerns forgiveness of debt, which occurs when a lender forgoes repayment of principal and/or interest the borrower owes.

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Typically, discharged debt is considered ordinary income to the borrower for income tax purposes. The new law allows taxpayers to exclude this amount and thus escape the tax liability.

"When you're worried about making your payments, higher taxes are the last thing you need to worry about. So this bill will create a three-year window for homeowners to refinance their mortgage and pay no taxes on any debt forgiveness that they receive," President Bush said in his remarks upon signing the law.

3 new tax breaks:
1. Homeowners who experience a foreclosure, short sale, deed in lieu of foreclosure or loan modification may be able to exclude lender-forgiven mortgage debt from taxable ordinary income.
2. Homeowners may be able to deduct the cost of mortgage insurance.
3. A homeowner whose spouse has died may be allowed up to two years to exclude $500,000 of profit from the sale of a principal residence from capital gains tax.

Lenders are required to report forgiveness of debt to the Internal Revenue Service, which means taxpayers likely will need to note the amount and the reason for the exclusion on their tax returns. Consult a qualified tax professional for more information and advice about your situation.

Rules for debt forgiveness:
The debt must have been discharged by the lender in 2007, 2008 or 2009.
The amount of debt that can be excluded is limited to $2 million.
The exclusion can be used only if the loan was taken out to acquire, build or substantially improve a principal residence. Forgiveness of debt on vacation homes, second homes and investment property doesn't qualify.
Debt forgiven on a cash-out refinance or home equity loan must be apportioned between the amounts used for home acquisition, construction or improvement and amounts used for other purposes such as tuition, travel or repayment of other debts. Only the allowable portion qualifies for the tax break, says John W. Roth, a senior tax analyst at CCH, a provider of tax services, software and information in Riverwoods, Ill.

Exceptions allowed for nonrecourse loans, insolvency, bankruptcy
It's difficult to figure out how many people might qualify, because three existing exemptions already shielded many homeowners from this tax liability, according to Sterling Watkins, mortgage broker and owner of Short Sale Services in Folsom, Calif.

"In my experience, the amount of people who will benefit will be small because most of them, if they qualified for a short sale, didn't have a (tax) problem," he says.

Next: "They basically follow you around until they get the money back."
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