Sub-prime Mortgage Debt Relief and the IRS

By Cameron Street

The downturn the housing market is currently experiencing was both predictable and inevitable. Speculative buying spread throughout many areas of the country fueled by the unprecedented availability of loans to borrowers in the sub-prime credit category as well as other types of high risk adjustable rate loan products. Wall Street and its investors in these loan products, called mortgage-backed securities and the now notorious collateral debts obligation (or CDOs) sparked this combustible cycle with their insatiable appetite for yield and their willingness to take on imprudent levels of uncharted risk. Sadly many of the borrowers who acquired their homes through either sub-prime or the high risk ever-rising-property-value dependent adjustable rate loan products are now faced with the fact that the party has ended and they are going to be left with a huge debt hangover. Foreclosure is on the horizon for a high percentage of these borrowers but tragically their problems will not end there. As if losing ones home and the resulting devastating blow to ones credit weren't enough, many homeowners may not be aware that debt cancellation (also called forgiveness) by your lender will result in a 1099 being generated with your name on it in the amount of the unpaid debt. Essentially, the IRS is going to tax you on the amount of debt cancelled or forgiven by a lender as if it were ordinary income you received within that year.

The debt you believed to be wiped out or "forgiven" by your lender is actually treated as income to you. For example if you were to borrow $250,000 from a lender to purchase your home and then you were to pay back only $50,000 and proceed to go into default on your payments after that, the lender will write off $200,000 in remaining outstanding debt which was owed by you and you would then receive a Form 1099-C (Cancellation of Debt) upon which ordinary income tax would be due. If interest on the mortgage is also forgiven, that could appear on the 1099-C as well depending upon whether or not the interest was tax deductible. Whenever personal debt is cancelled by any type of lender or creditor, the amount that is cancelled or forgiven is treated as ordinary income by the IRS unless the borrower in question is declared bankrupt or insolvent. A borrower would be deemed to be insolvent if after reducing the amount cancelled or forgiven debt from their original liabilities, the total outstanding debt still exceeds the borrower's total assets. You would claim relief of this kind on IRS Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) if applicable in your particular case.

However fortunately help may be on the way, The Mortgage Cancellation Tax Relief Act of 2007 (HR 1876) would attempt to expand protection from the IRS by shielding those borrowers who are not bankrupt or insolvent. The bill would in essence amend the tax code to exclude debt forgiveness on mortgages secured by a primary residence from being treated as ordinary income. It is interesting to note that this change or amendment would simply be a return to IRS policy prior to the last infamous lending debacle, also know as the Savings and Loan Crisis. This legislation could also assist the expanding number of homeowners who are on the brink of foreclosure and are considering either a "short sale" or a "deed-in-lieu of foreclosure". A short sale involves selling your home for less than the amount of the mortgage(s) secured against it and a deed-in-lieu of foreclosure is simply an agreement between you and your lender that will permit you to turn over your deed or ownership of the property to your lender rather than proceeding with the foreclosure process, both aforementioned events would currently trigger a 1099-C from your lender. The bill is currently in committee where it will be reviewed prior to proceeding onto a vote by Congress. If passed this could result in easing the nation's sub-prime mortgage debt hangover to the tune of $2 billion in debt relief, a welcome tonic indeed.

Always consult with your tax or financial advisor regarding your own individual circumstances before proceeding with any plan which may have a dramatic impact on your personal finances.

Alternative Minimum Tax Deadline Looming for Legislators

Lawmakers in Washington are scheduled to adjourn on November 16th and if they don't act by then an ever increasing number of taxpayers, about 25 million to be precise, are going to be hit with the so-called "wealth tax" also know as the alternative minimum tax or AMT. The vast majority of taxpayers that will be impacted in 2007 are going to be introduced to the AMT for the very first time and it will not be a pleasant introduction as the effected taxpayers will pay on average an additional $2,000 in income tax resulting from the AMT. To make matters worse, if congress fails to act fast enough, 25-50 million taxpayers could face a delay in the processing of their federal tax returns and consequently a delay in receiving their refunds.

The Internal Revenue Service (or IRS) needs at least 12 weeks to process any changes made to the alternative minimum tax (or AMT) from the time that new legislation is passed into law. The re-programming that is involved within the IRS computer system requires millions of lines of coding which cannot be implemented over night and will require time for testing as well. Unfortunately the AMT is an integral part of the IRS processing system and much time will be needed to alter it. Therefore should congress delay until December in making any AMT changes, the IRS would not be able to process some 25 to 50 million returns until the mid-March time frame at the earliest. Of course the deadline to file a return is not until April 15th however those taxpayers anticipating a refund tend to file their returns far ahead of that deadline and for the 2006 tax year, the average refund amounted to approximately $2,260. The IRS is scheduled to send its 1040 instruction forms to be printed on November 7th and the agency should be ready to begin processing 2007 tax returns by mid-January.

Unfortunately policy watchdogs and Washington insiders predict that major AMT reform legislation will not occur prior to 2009 and therefore would not go into effect until 2010 at the earliest. The best alternative for taxpayers would be if lawmakers were to pass a "patch" for 2007 which would prevent taxpayers with income levels at $45,000 (for joint filers) and $33,750 (for single filers) from being affected by the AMT this year. A patch was successfully implemented in 2006 which effectively raised the AMT exemption levels to $62,550 (for joint filers) and $42,250 (for single filers). The uncertainty surrounding the current AMT status has professional tax payers ready to pull their hair out as they have no way of currently determining which of their clients will be impacted.

The alternative minimum tax (AMT) was originally conceived 40 years ago to prevent a small number of high wealth individuals from eluding taxes altogether, a flaw in the tax system at the time actually allowed this to occur. The problem with the AMT system today is that it has not been indexed to the median income levels within the various geographic regions throughout the United States. Therefore the AMT tends to hit the residents of expensive coastal and urban areas disproportionately to the rest of the country. There is of course strong taxpayer support for correcting the inequities within the AMT system however the political support to do so is now limited to solutions which are revenue-neutral and will replace the $500 billion to $1 trillion in revenue that is expected to be generated from the AMT over the next decade. This is where the catch-22 arises as there is no agreement amongst legislators on how to replace the AMT generated revenues and there are now other looming political crisis's taking the spotlight away from AMT reform, such as the recent sub-prime mortgage debacle.

Beware of the potential impact of the AMT on you and your family if:

> You have a combined household income is in excess of $100,000.

> You take multiple itemized deductions, exemptions or credits which may not be permitted under the AMT system.

> You don't itemize your deductions. AMT does not allow the standard deduction.

> You have dependents or children. Personal and dependent exemptions are not permitted under the AMT system.

> You are a resident of a high income tax state. Even state, local and property taxes are not deductible under the stringent AMT system.

> You receive income from municipal bonds which is not subject to standard income tax but is subject to the AMT.

> Exercising stock options (or ISOs) is a large and notorious trigger for the AMT to come into play.