Mortgage Forgiveness Debt Relief Act

The Mortgage Forgiveness Debt Relief Act (“Act”) was enacted in 2007 to allow an income tax exclusion to taxpayers who have had a debt cancelled or discharged on their primary residence.  Prior to the enactment of this Act, if a taxpayer’s debt was discharged or cancelled it had to be reported as income on the taxpayer’s income tax returns, with some exceptions.  Beginning in 2007, the Act allowed taxpayers who were going through a foreclosure action or modifying the terms of their mortgage on their principal residence, to exclude the forgiven portion of their debt from their income tax returns.

The Act expired at midnight on December 31, 2013. Going forward, taxpayers who are going through a foreclosure or any mortgage modification will have to report any cancelled debt as income on their tax returns for the 2014 fiscal year.  Meaning, taxpayers who are struggling financially and losing their homes, will be hit with a massive tax bill to boot.  Although there are two bills in Congress proposing an extension of the Act, to date the Act has not been extended.

An issue of controversy exists as a result of this expired Act.  When a taxpayer receives a waiver of deficiency at the conclusion of a foreclosure proceeding, is the debt considered discharged or cancelled from the time the waiver is granted or from the time the sale of the property is finalized?  For example, if a taxpayer’s property was foreclosed in 2013 and the bank granted a waiver of deficiency at that time (i.e. a bank waives its right to come after a borrower for the difference between the fair market value of the foreclosed property and the debt which the taxpayer owed on the property), but the property is sold in 2014, will the taxpayer be able to exclude the cancelled debt under the Act because the deficiency was granted in 2013; or will the taxpayer have to report the cancelled debt as income on their 2014 income tax returns?

The answer remains unclear.  Generally, the Internal Revenue Service treats a foreclosure as a sale. And when a debt is cancelled or discharged, the IRS requires that the creditor cancelling or discharging the debt provide the taxpayer with a Form 1099c. The instructions to filing this form indicate that a debt is considered cancelled under nine (9) different circumstances.  Particular to the situation, item number 2 indicates:

A debt is deemed canceled on the date an identifiable event occurs or, if earlier, the date of the actual discharge if you choose to file Form 1099-C for the year of cancellation. An identifiable event is one of the following.

    1. A cancellation or extinguishment making the debt unenforceable in a receivership, foreclosure, or similar federal nonbankruptcy or state court proceeding. Enter “B” in Box 6 to report this identifiable event.
    2. ….

It could be argued that a waiver of deficiency makes the debt unenforceable in court proceedings.  Furthermore, the instructions dictate:

When To File: Generally, file Form 1099-C for the year in which an identifiable event occurs. See Exceptions, later. If you cancel a debt before an identifiable event occurs, you may choose to file Form 1099-C for the year of cancellation. No further reporting is required even if a later identifiable event occurs with respect to an amount previously reported. Also, you are not required to file an additional or corrected Form 1099-C if you receive payment on a prior year debt.

So there is some discrepancy as to when the form will be filed, at the time of the “identifiable event” or at the time the debt is actually cancelled.  However, since the IRS form 1099c is a cash basis form, it likely that the debt is considered cancelled on the date of the sale of the property.

As it stands today, unless Congress acts on any of the bills it is currently presented with, the Mortgage Forgiveness Debt Relief Act is a thing of the past.  Taxpayers who are currently going through foreclosure proceedings or mortgage modifications of any kind, should take into consideration the tax implications which they may face going forward.