Homeowners who went through foreclosure in 2007 could receive a benefit on their federal income tax return thanks to the Mortgage Forgiveness Debt Relief Act of 2007. Under the new law, taxpayers no longer have to pay tax on the value of their home loan if the loan was cancelled through a foreclosure proceeding, otherwise known as "cancellation of indebtedness income."
The indebtedness relief benefit applies only on a primary residence — not second homes or investment properties — and is limited to the first $2 million of mortgage indebtedness on foreclosures on or after Jan. 1, 2007 and before Jan. 1, 2010. The sticky point, however, is that refinances made between the time of purchase and foreclosure could muddy the waters.
For example, if you refinanced your loan and took cash out of the property to pay for cars, vacations and other real estate, the amount of your loan when it went into foreclosure could have been far greater than the original debt. The relief limit stops at the amount of the original debt, minus what you have paid in principal. Money borrowed for capital improvements can be added to the original debt figure.
"You should look at this debt as purchase money debt, unless the refinance money was expressly used to improve the primary residence," said Joe DiPaola, real estate broker, lawyer and former executive with Coldwell Banker.
The new law is a bit different than the guideline for mortgage interest deductions — a write-off that many taxpayers exceed by taking a greater a greater deduction than allowed. You can deduct interest only on the original amount of the loan, plus $100,000 of home-equity debt. For example, let’s say you purchased your home 10 years ago for $100,000 and took out a loan for $80,000. Since then, you have paid the loan down to $20,000.
The house is now worth $275,000 and your oldest child needs college tuition. The house definitely has equity to tap, but your mortgage interest deduction would be limited to the first $120,000 — $20,000 old loan at the time of "refi," plus $100,000. (The Mortgage Forgiveness Debt Relief Act of 2007 does not allow the extra $100,000 of home-equity debt).
"The Mortgage Forgiveness Debt Relief Act does not go far enough to solve the problem," DiPaola said. "Lenders continue to foreclose and write-off loans in record numbers, whether or not the owner gets a relief benefit. And, the new law does nothing to help with the consumer’s credit because of the foreclosure. The borrower’s credit is ruined.
"The real solution is to create an incentive for lenders to do more loan workouts and restructure their loans with owners, so that owners don’t go to foreclosure in the first place."
Other industry officials say many of the borrowers who face foreclosure are not naive first-timers who were led down the road with hard-money, subprime loans. According to several national lenders, a majority of the homeowners who are desperately seeking relief now were the same people who were desperately seeking extra toys, or larger homes and slicker neighborhoods, over the past few years.
Also deductible on your 2007 return is the cost of qualified private mortgage insurance, or PMI. "Qualified" premiums are premiums paid on a loan used to acquire a principal residence in 2007. The mortgage insurance deduction phases out when income is greater than $100,000 for couples and $50,000 for singles. This new deduction is in addition to the mortgage interest homeowners have been able to deduct.
It is important to remember that home-loan interest deductions simply reduce your taxable income. They are not dollar-for-dollar tax credits that are subtracted from your tax bill. If you have a $1,000-a-month mortgage payment and are in the 15 percent tax bracket, only about $150 a month escapes being taxed in the early months of the loan.
You can deduct the loan fees ("points") paid to buy or improve your main home in the year of purchase. You cannot deduct these fees in the year you refinanced if you refinanced only to obtain a lower interest rate on your loan.
The term "points" once used to describe only prepaid interest on government loans, but now is used to describe charges paid by a borrower to secure any mortgage. These points can be loan origination fees or prepaid interest to "buy down" an interest rate. To be deductible, these charges — or points — must represent interest paid for the use of money and must be paid "before the time for which it represents a charge for the use of the money."
To get even more valuable advice from Tom, visit his Second Home Center.
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