After much anticipation and a full year of home owners facing foreclosure sweating it out, H.R. 3648 – Public Law 110-142 was finally signed into law December 20, 2007.

One of the pitfalls of a short sale or foreclosure is that any debt amount forgiven or discharged by the lender is recognized as taxable income by the IRS, and then taxed at ordinary income rates for the home owner, even though no actual cash changes hands. The taxation of “fake” money was just another kick in the pants to homeowners who just lost their home to foreclosure, only to find a huge tax bill in the mail that most could not afford to pay. The Act was given a boost of support with the number of foreclosures and the mortgage/financial crisis, not to mention the decreasing home values happening across the country.

So now, with the passage of the H.R. 3648, individuals who are relieved of their obligation to pay some portion of a mortgage debt on a principal residence between January 1, 2007 and December 31, 2009 will not be required to pay income tax on any amount that is forgiven.

Here are some details that might apply to you:

• No Income Limitation: All borrowers receive the relief, no matter what their income.
• Dollar Limitation: No more than $2 million of mortgage debt is eligible for the exclusion ($1 million of debt for a married filing separately return).
• Relief applies only to an individuals principal residence and the forgiven mortgage debt must have been secured by that residence.
• No relief is available for cash-outs, whether the cash-out takes the form of a refinanced first mortgage, a second mortgage, home equity line of credit or similar arrangement.
• Eligible debt is what is called “acquisition indebtedness.” This is debt used to acquire, construct or rehabilitate a residence.
  1) Refinanced debt qualifies, so long as the debt does not exceed the original amount of the debt. (Same rule as Mortgage Interest Deduction)
  2) Home equity debt (or second mortgages) qualifies if the funds were used to improve the home. (Borrower must have adequate records, as under current law.)
  3) See cash-outs, above. No amount of a cash-out may be treated as acquisition debt.

Here are a few points of clarification as supplied by the Minnesota Association of Realtors:

• Refinanced Mortgages: The relief does apply to refinanced debt in some circumstances. The rules seek to assure that any debt eligible for the relief is directly related to the acquisition or improvement (such as rehabilitation, expansion, renovation, reconstruction) of the principal residence. Debt used for furnishings (i.e., any movable property) in the home is not eligible for the relief. When the proceeds of any refinanced debt is used for any purpose other than acquisition or improvement, those proceeds are not eligible for the relief.
• Principal Residence: A principal residence is defined in the same manner as the rules that apply to the capital gains exclusion on the sale of a principal residence. An individual may not have more than one principal residence at any given time.
• Second Homes: As a general matter, the relief does not apply to any debt forgiveness on any mortgage for any second home of the taxpayer. However, if a taxpayer uses a residence (other than his principal residence) solely as an income-producing rental property, already-existing relief provisions might apply, depending on the taxpayer’s situation. if the second home property was acquired as a speculative investment (such as for resale rather than rental), relief provisions are unlikely to be available. In all events an individual who is in a short sale, foreclosure, workout or similar situation on a residence (including condos) other than his principal residence should consult a tax adviser to determine what, if any, relief provisions might be available.

Some other points of interest that are tacked on to the Mortgage Debt Cancellation Relief Act are the following:

Mortgage Insurance Premiums: The deduction for mortgage insurance premiums is extended through tax year 2010. Income limitations on the deduction will continue to apply.

Surviving Spouses/$500,000 Exclusion: In some circumstances, a surviving spouse is denied eligibility for the full $500,000 exclusion on the sale of his/her principal residence. This most frequently occurs when the residence is not held in joint ownership at the time the spouse who is not on the title dies. In that case, the deceased spouse had no ownership interest, so there is no basis step-up on that half of the property. the surviving spouse is thus eligible only for an exclusion of $250,000. (Had the home been sold during the deceased spouse’s lifetime, the full $500,000 exclusion would have applied, so long as they filed a joint return.) Challenges for the surviving spouse are compounded when this circumstance occurs late in the year. The surviving spouse is often unable to sell the property within the same year that the spouse died. This legislation provides that a surviving spouse may claim the full $500,000 exclusion not only in the year of the deceased spouse’s death, but also during the two years after the spouse’s death.

Second Homes Converted to Principal Residence: The original House-passed version of this legislation included a provision that would have limited the application of the $250,000/$500,000 exclusion when a second home is converted to a principal residence and later sold. Thankfully, this change was not included in the final legislation that the President signed, as it would have hurt those that own second homes with huge capital gain taxes.