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The Tax Prophet Newsletter   Issue # 56 December, 2007


In This Issue:
The Act
The "Catch"
Residence Exclusion

The Mortgage Debt
Tax Relief Act


On December 20, 2007, President Bush signed the Mortgage Forgiveness Debt Relief Act of 2007 (the Act) to alleviate the tax pain caused by the recent residential real estate meltdown. The legislation provides tax relief for those losing their homes to foreclosures or renegotiating a lower mortgage debt.

As discussed in the October, 2007 newsletter, under the tax law cancellation of debt (COD) is usually treated as ordinary income.

The Act

The Act excludes from gross income any COD income involving "qualified principal residence indebtedness" (qualified debt), which is debt incurred for the acquisition, construction or substantial improvement of, and secured by, a principal residence. The Act limits qualified debt to $2 million ($1 million for married filing separately).
Note: Debt secured by a principal residence but used to purchase investment assets or for personal expenditures will not qualify.

The "Catch"

Unfortunately, there is no free lunch: the adjusted basis of the residence will be reduced, dollar for dollar, by the amount of COD income excluded under the Act.

Upon foreclosure or sale, the taxpayer will have income on the amount excluded (usually capital gains taxed at 15% federal for a residence held at least 12 months), which is a better outcome than receiving ordinary income (taxed as high as 35% federal).

In addition, any capital gains may be offset by the residence exclusion, if applicable.

This is a similar result to the non-recourse mortgage rules (discussed below).


In most cases, under California's anti-deficiency statute (CCP 580b) a lender's right to satisfy a debt is limited to the residence (the borrower is not personally liable for the debt), which means the debt is "non-recourse" with respect to the borrower.

The Act does not apply to non-recourse debt because, under the tax law, there is no COD income upon the sale or foreclosure of property encumbered by non-recourse debt. Instead, the transaction is considered a sale of the property for the full amount of the debt, and the taxpayer incurs either a capital gain or loss.

As illustrated by the examples below, under the Act it may no longer matter whether the debt was recourse or non-recourse.

Example 1: Assume taxpayer purchased a principal residence worth $1 million, paying $100,000 down and borrowing $900,000 of non-recourse qualified debt. When the property is worth $700,000, the lender forecloses. The transaction is treated as a sale for $900,000, the full amount of the debt.

The taxpayer's adjusted basis is $1 million (the $100,000 down payment, plus $900,000 debt = $1 million), so the taxpayer has a $100,000 capital loss, calculated as follows: sale of the property for $900,000, minus a $1 million adjusted basis = $100,000 loss.

Note: The actual sales price is ignored under this calculation.

Example 2: If the debt were recourse, the taxpayer would have a COD income of $200,000. The Act excludes the income and reduces the adjusted basis by $200,000.

The property is sold for $700,000, resulting in a $100,000 capital loss, calculated as follows: sales price of $700,000, minus the $800,000 adjusted basis (the original $1 million basis, less the $200,000 basis reduction under the Act) = $100,000 capital loss.

Note: Under old law, the taxpayer would have $200,000 of COD income and a $300,000 capital loss, but the capital loss would not offset the COD income (except as to $3,000 per year). Consequently, the Act causes a capital loss to offset COD income.

Residence Exclusion

The Act provides an additional bonus: the residence exclusion of $500,000 allowed a married couple will be available for a sale occurring within two years the death of a spouse.


The Act excludes from gross income the discharge of qualified debt to a maximum of $2 million. As it turns out, the result is the same whether the debt was recourse or non-recourse - the transaction is essentially recast as a sale and COD income is converted to capital gains by the equivalent adjusted basis reduction in the residence.

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All contents copyright 2007 Robert L. Sommers, attorney-at-law. All rights reserved. This newsletter provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet is a registered trademark of Robert L. Sommers.