I thought I’d take a minute to update you on a piece of legislation that needs more attention but isn’t getting it. That’s the Mortgage Relief Debt Forgiveness Act, which started off life as a separate bill but has since been folded into the same AMT relief bill Congress is trying to get passed right now.
The Mortgage Relief Act is a reactionary piece of legislation aimed at helping people who face foreclosure on their principal homes, or those who are participating in short-sales. It’s designed to cut out the tax paid on debt forgiveness amounts where the debt exceeds the sale price.
For example, let’s say a homeowner got a 125% loan on a $100,000 house. That means he owes $125,000 on a home worth only $100,000. If he subsequently loses the home to foreclosure, he will wind up with a debt forgiveness of $25,000. (He actually had $125,000 forgiven but the house’s value offset $100,000 of that debt). The remaining $25,000 is considered ordinary income and he has to pay tax on it.
The massive increase in foreclosures has brought claims that this is unfair, and that taxpayers already facing financial disaster shouldn’t have a tax bill added to their misery. So Congress is stepping in to help out by exempting debt forgiveness from taxation.
But under PAYGO rules, every tax cut has to have a corresponding revenue offset. If this bill becomes law other homeowners will feel the impact.
Right now if you live in your home for two of the previous five years you can exclude up to $500,000 of the gain on sale (married, filing jointly) or $250,000 if you file as single. And because “living in” is a flexible term, it allows homeowners a lot of freedom to change locations without losing this fantastic tax break. But under this new law, you’d have to live in the home for all five years to get the full amount – anything less would mean only receiving a pro-rata deduction.
Lawmakers point out that this bill is supposedly aimed at the sales of second homes, but I’m concerned that this bill is going to hit other people, too. For example, if you relocate and rent out your home until the market rebounds, you will be caught in this new definition. Even though you’re doing the responsible thing, renting out your existing home would now mean turning a tax-free capital gain on the eventual sale into a taxable capital gain. And if you’re subject to AMT you lose the lower 15% capital gains tax rate. Talk about a double whammy!
If this new bill becomes law, you may be better off letting the bank take back the home. You’ll have a ding to your credit on one side, but you won’t have to make the effort to rent it out and hang on until the market recovers. No tenant hassles. No bookkeeping work. And the government bails you out!
To me, this solution feels counter-productive and goes against the whole philisophy of providing tax loopholes and tax credits to people who do what the goverment wants – buy real estate and create businesses to help our overall economy.