Congress Contemplating Tax Relief for Homeowners in Foreclosure

Homeowners who lose their homes in a foreclosure sale may end up with a substantial tax liability for forgiven debt (see my prior article on this subject).  The Foreclosure Tax Relief Act of 2007, currently being discussed by the House Committee on Ways and Means, offers much needed tax relief for people who owe more on their primary residence than it can currently be sold for.

The bill modifies §108 of the Internal Revenue Code to add discharge of indebtedness on residential property to the list of exclusions from gross income.  The proposed exclusion would only apply to mortgage indebtedness incurred to acquire, construct, or substantially improve real property owned and used as the principal residence during at least two of the five years preceding discharge, or from refinancing a loan meeting those qualifications.  There is a cap of $50,000, and taxpayers with an adjusted gross income over $100,000 ($200,000 if filing jointly) are not eligible.

These exclusions are significant.  Many home refinance transactions include a significant cashback or money to payoff outstanding debts, in addition to finance charges and closing costs.  It is not clear to me, from the language of this bill; whether a person who owed $150,000 on a personal residence, incurred a refinance debt of $175,000 to obtain cash and convert from a variable to fixed rate mortgage, and then subsequently sold the house for $150,000 would be liable for taxes on the $25,000 difference.  This type of mixed refinancing debt is not uncommon.

The proposed cap of $50,000 already underestimates the extent to which recently-acquired ordinary single-family houses have depreciated in some of the most inflated markets nationwide, and assumes that the housing slump is bottoming out.  For many people, the relief proposed by this bill will be only partial if their income level allows relief them at all.

Some of the very real problems this bill seeks to address result from lender foreclosure and underreporting of property values.  By relieving the homeowner of a phony tax burden generated by lender error, the Foreclosure Tax Relief Act, even as presently configured, will be a significant improvement.

In short, the bill is good as far as it goes, but falls short of a complete fix for a problem which is likely to worsen in months to come.