In an effort to help struggling homeowners, Congress recently passed the Mortgage Forgiveness Debt Relief Act of 2007. This will help struggling homeowners who have had to either restructure their home loans with a lower principal balance on the new loan, or sell short (so they do not clear enough from the sale to pay off the existing principal balance). It will also help owners who have actually lost their homes by foreclosure if the lender has sold the house for less than the existing principal balance.
In all of these cases, the owner has been forgiven or relieved of some debt.For example, if a homeowner purchased a principal residence with a $1,000,000 loan but could only pay off $900,000 when it was sold, the owner would have been relieved of $100,000 in debt that they no longer have to pay off. Prior to the passage of this law, the $100,000 would be considered ordinary income by the IRS, with only a very few exceptions. The exceptions did not include homeowners who were relieved of debt on their principal residence.
This new act corrects that, which will be a great relief to homeowners who find themselves in this unfortunate position, but there are some strict rules.
In summary:
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The tax relief is limited to principal residences;
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The tax relief is limited to acquisition indebtedness plus improvements on the property. Second mortgages and equity loans are not covered unless they were used to acquire, construct, or substantially improve the home.
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The tax relief must have occurred in 2007, 2008 or 2009.
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The tax exemption is limited to $2,000,000 ($1,000,000 for married individuals filing separately.)
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If the debt relief is part of a restructuring where the principal balance is lowered, the basis of the house is lowered by the same amount. This will lead to a larger profit if the house is sold at a later date and could lead to taxation at the time of sale if the profit exceeds the $250,000/$500,000 exemption for the sale of a personal residence
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