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Mortgage Debt Forgiveness & The Mortgage Debt Relief Act

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There is no more optimistic day than when you open the front door on a new home.

Unless of course, someone handed you that key somewhere around 2006 or so.

A year later, the economy was melting down and home values led the way. More than five million houses went into foreclosure in 2008-2009, leaving millions of homeowners begging for help with mortgage payments.

Fortunately, despite a spike from the COVID-19 pandemic, the number of upside-down mortgages in 2021 has not reached the low of the dismal heart of the Great Recession, when it seemed no neighborhood went unaffected.

But underwater mortgages still exist, and if you’re in one of them, you can’t be blamed for wanting a way out.

Luckily, debt relief options for mortgages remain available, including a tax break through the Mortgage Forgiveness Debt Relief Act, which forgave taxes on discharged mortgage debt up to $2 million through 2020. The Consolidated Appropriations Act, passed in December 2020 as pandemic relief extends tax exclusion of discharged mortgage debt through 2025, with a maximum of $750,000.

If you’re looking for mortgage debt relief, maybe it’s time you got busy.

Mortgage Forgiveness

Mortgage forgiveness means exactly what the term suggests: The lender actually forgives some or all of the debt you owe. That is, it simply wipes away that portion of your debt.

Mortgage lenders are not in the business of forgiving debt. When you close on a house, executing your mortgage, it’s with the expectation you will pay it back during the time allotted. Only when the lender is convinced you will be unable to pay it back will it concede to forgiveness provisions.

One way this happens is through a loan modification program — that is, you negotiate new terms for your original loan. You might get a lower payment in exchange for a lengthier payout period. That means that ultimately, you will be on the hook for more than you otherwise would have been, but at least you’re still in a home.

Another way mortgage debt forgiveness occurs is in foreclosure, when the home that stands as collateral in the mortgage is seized by the lender for nonpayment.

Long before a lender considers debt forgiveness, it will attempt to work with its troubled borrowers. After all, it extended the mortgage — a loan of money guaranteed by your house — in anticipation of being paid back at some point. Believe it or not, your lender doesn’t want your house; most of them are reluctant participants in the distressed real estate industry.

Now, not all loan modifications involve debt forgiveness, nor do all foreclosures, especially if there’s sufficient equity in the house. Another way to avoid mortgage forgiveness — which, for the good of your credit rating and, possibly, your income tax bill, you really want to do if at all possible — is simply by refinancing, especially if there’s significant equity in your house.

How to Get Mortgage Forgiveness in 4 Steps

Getting mortgage forgiveness — again, a reduction in your home loan principal balance — will involve some negotiation. After all, it involves rewriting your original contract.

Typically, lenders consider two types or mortgage forgiveness plans. In one, you stay in your home under rewritten terms. In the other, you move out, but avoid foreclosure.

Whichever mortgage debt forgiveness option better suits you, understand there might be tax implications, meaning you might have to add whatever amount was forgiven to your gross income.

You also might be subject to a deficiency judgment, which happens when the sale of your property doesn’t cover what you owe. If that happens, the lender can take you to court and get a deficiency judgment, which essentially is a lien against you saying you still owe lender money.

There are steps you can take to get debt relief for your mortgage.

Step 1

Begin by contacting your lender to ask about mortgage forgiveness options. Homework is important before you launch. You must be able to explain your financial situation as well as answer questions that elaborate on your finances and circumstances.

Perhaps you can arrange a mortgage modification, reducing some or all of the principal you owe on your mortgage.

A short sale would allow you to sell your home for less than the outstanding balance due and walk away. This is one version of the move-out-and-avoid-foreclosure gambit.

Another version is “deed in lieu of foreclosure,” in which ownership is transferred to the lender to satisfy the debt.

Step 2

Gather your financial documents. Whether you’re seeking a loan modification, short sale, or deed-in-lieu, lenders need to review substantiation of your financial fix: two recent bank statements, proof of income, the two most recent years of tax returns, and a list of monthly expenses.

Getting a short sale approved involves the listing agreement, a sales contract, a closing-costs statement, and the buyer’s proof of funds.

Step 3

Write a letter detailing your financial hardship. Explain why you can no longer afford to pay off the principal balance.

Specify the hardship(s), such as job loss, prolonged illness or disability, or other financial reversal, and provide a list of the actions you took to avoid default.

For a deed-in-lieu, you may need to explain why you previously were denied a loan modification or refinance option and failed in an attempt to secure a short sale.

Step 4

Request a letter from your lender that states precisely the terms of your mortgage forgiveness arrangement. A key element: The letter should identify the amount of principal the lender agrees to wipe clean or forgive.

If going the short-sale route, the approval letter should spell out that the lender agrees to waive its right to any deficiency — the difference, as described above, between the amount owed and the sales price.

Mortgage Forgiveness and Debt Relief Act

This vestige of the Great Recession, passed in late 2007 during the George W. Bush administration, then extended by Congress five times under presidents Obama and Trump, allowed — under limited circumstances — debt forgiven by mortgage lenders to be excluded from the borrower’s tax return with a maximum of $2 million. This includes any discharge or mortgage restructure through 2020, and into 2021 if the agreement was signed in 2020. In December 2020, the similar Consolidated Appropriations Act was passed, which has a maximum $750,000 and is extended to 2025.

Before the act was passed (and extended), borrowers who were forgiven debt, whether outright or when the lender didn’t chase the borrower for the difference when a foreclosure resold for less than the original mortgage, was considered regular income.

The IRS required the amount to be listed in the year the debt amount was waived. For example, before the act, if you were forgiven — for whatever reason — $20,000 on an underwater mortgage, when you filed your taxes the following year, that $20,000 would have to be accounted for, and would be taxed at the prevailing marginal rate.

While the 2008 meltdown was raging, Congress recognized this arrangement as an especially undue hardship — injury, meet insult — and passed the first Mortgage Forgiveness and Debt Relief Act.

Under the act, taxpayers were able to exclude up to $2 million in debt forgiveness, whether through foreclosure, short sale, or some sort of mortgage modification. The key stipulation: The waiver had to be made on the taxpayer’s qualified principal residence. Second homes and vacation homes did not qualify. The act has been extended five times since it first passed, and, as noted above, the latest extension, in December 2020, reduces the cap to $750,000.

Treatment of Canceled Debt and Taxable Income

Despite the extensions, Congress has declined to make the mortgage forgiveness exclusion permanent. With the latest pandemic stimulus figure greatly reduced from the original $2 million and terminated in 2025, future extensions are unlikely.

Once the exclusion is gone, we’ll be back to the old rules — Internal Revenue Code Section 61[a][12] —  and only by declaring bankruptcy or legal insolvency will those forgiven mortgage debt on their principal residence be able to avoid taxes on the amount waived.

If you own a farm, you may have more luck getting canceled debt excluded from taxes. There are three elements that will allow farming debt to not be considered taxable. The debt has to be directly tied to operation of the farm; more than half of your income from the prior three years has to be from farming; and the creditor has to be a person or agency regularly engaged in lending. As with most tax policy, there are a lot of ins and outs to this, so it’s best to get help from a tax professional in order to get the best bang for your buck.

Other instances when canceled debt isn’t considered taxable by the IRS are:

  • A seller giving a buyer a qualified property purchase price reduction.
  • Amounts canceled as gifts, bequests, devises, or inheritances
  • Several student loan exceptions, including those that are canceled with the provision that the borrower work for a certain period of time in certain professions; repayment or loan forgiveness programs that provide health services in certain areas of the country; those discharged because of death or total and permanent disability of the student.
  • Amounts of canceled debt that would be deductible if the borrower, as a cash basis taxpayer, paid it.

Most mortgages are “recourse loans,” which means the lender can take back the house – the collateral – if the borrower can’t pay, and then take other assets if the value of the house doesn’t cover what’s owed (the deficiency judgment). In 12 states, though, mortgages are non-recourse loans, which means the lender can only take the collateral, and no more. In a foreclosure on a non-recourse mortgage, taxes on debt income are not canceled.

Other Options to Mortgage Forgiveness

If this date with the IRS sounds ominous, it should. If it has you thinking about other options to your underwater mortgage conundrum, all the better.

If you’re certain you can’t achieve a livable refinancing arrangement and losing your home is certain, consider these options. (Some, alas, still involve ponying up on your tax return.)

Short sale: In a short sale, a lender agrees to accept the sale price of your home as payment in full on your mortgage. Yes, even if the house sells for less than you owe. Again, however, there’s that cancelation of debt problem, triggering a tax bill. The house goes on the market just as any other house, and — knock on wood — you receive offers as you normally would. You forward them to the lender, who decides which one to accept. When an offer is approved, your house sells, and you move out. If there’s a deficit, you’re not on the hook … except to the IRS.

Deed-in-lieu of foreclosure: This is the old hand-over-your-keys-and-walk-away gambit. Rather than force your lender to go through the expensive, time-consuming process of a foreclosure, you leave your home voluntarily and sign it over to your lender. In exchange for not having to fight, the lender accepts your home and cleans your slate. If there’s a deficit when the house sells, the lender eats it … but also reports it to the feds, meaning, again, taxes will be due.

Nonjudicial foreclosure: As opposed to a typical court-ordered foreclosure (you lose your house, and the lender can come after you for any deficit when the house resells), in a nonjudicial foreclosure, the lender sells your home at auction; the money realized is used to pay off your mortgage. Any shortage is forgiven. The arrangement has to be approved by your lender, and hinges on your cooperation throughout the process — including a guarantee you will keep the property in good condition.

Second mortgages: If you’re over your head with your first mortgage, and you already have a second, that’s probably in trouble, too. And if your house is lost to foreclosure or short sale, especially in an underwater market, the holder of the second mortgage may have few options besides pursuing you in court for wage garnishments or other attachments. (If the second-mortgage lender forgives your debt, there will, again, be income tax ramifications.) Be proactive; attempt to settle your second-mortgage debt in a way that doesn’t linger into your post-house debt.

Downsizing Your Home: If the problem is too much house, and the payments that come with it, you may want to consider downsizing your home. In other words, you sell the bigger more expensive home, and find a smaller, cheaper place to live.

Bottom line

Still uncertain what to do? Consult with your lender. See what provisions can be worked out, including the possibility of refinancing your mortgage. A lower interest rate or longer term may result in monthly payments you can live with.

Or you may want to contact a nonprofit debt counseling service. They’ve heard worse stories than yours, and they are skilled at dealing with budgets, credit counseling and sorting out financial issues. They’ll have some ideas on options you might not have considered, such as housing and mortgage counseling.

About The Author

Bill Fay

Bill “No Pay” Fay has lived a meager financial existence his entire life. He started writing/bragging about it in 2012, helping birth into existence as the site’s original “Frugal Man.” Prior to that, he spent more than 30 years covering the high finance world of college and professional sports for major publications, including the Associated Press, New York Times and Sports Illustrated. His interest in sports has waned some, but he is as passionate as ever about not reaching for his wallet. Bill can be reached at [email protected].


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