In most parts of the country, landlords who have unloaded their homes have reason to celebrate. They have taken advantage of soaring house prices, especially since the pandemic began in early 2020.
The surges, however, offer cold comfort to budding sellers who owe more on their mortgages than their places are worth, with landlords known colloquially as upside down or underwater.
Luckily for the Upside Down, their plight has not gone unnoticed by our legislators, who have crafted carefully crafted legislation that benefits many of them, while doing absolutely nothing for others.
I have several columns that show accountants and other tax experts how to help desperate borrowers whose mortgages are foreclosed or who engage in short selling. What follows are reminders of how the IRS interprets the rules and ways for borrowers to reduce their taxes.
The basics. Section 61(a)(12) of the tax code generally requires debtors to report all canceled debts on their 1040 forms, similar to how they must report income from sources such as wages or investments. . They are also subject to tax at the rates imposed on ordinary income from sources such as pensions and distributions from Individual Retirement Accounts and other types of tax-deferred arrangements.
Some canceled debts avoid taxes. Section 108 of the Code specifies several carefully covered exceptions. One of them allows income exclusions for people whose mortgage debts have been canceled or canceled during mortgage meltdowns, transactions that real estate agents call “mods,” short for loan modifications, foreclosures, deeds in lieu of seizure and short sales.
Loan modifications or restructurings: These relief agreements ease normally reliable borrowers through difficult times. Lenders typically lower interest rates or lengthen payment terms, although many companies whose revenue is boosted by late fees are reluctant to help struggling borrowers.
Foreclosures: Usually, lenders lose a lot of revenue on foreclosed homes because they incur substantial costs to maintain and then sell these properties, often at steep discounts. Among other things, lenders who use real estate brokers will have to pay commissions when selling properties. Foreclosures typically only return lenders about 60 cents on the dollar.
Deeds in lieu of foreclosure: Defaulting borrowers agree to voluntarily transfer the title deeds to the lenders, who then waive their right to sue for amounts still owed. But lenders might require borrowers to try to sell their homes.
Short sales: These occur when a homeowner obtains approval from the lender to sell at a net price (gross sale price less legal fees, broker’s commission and other fees) insufficient to cover the entire debt unpaid.
Debt relief. Lawmakers first allowed special relief for debts eliminated in 2007, 2008 and 2009 (the Mortgage Forgiveness Tax Relief Act of 2007). Fast forward through several exclusion renewals, most recently in the Consolidated Appropriations Act of 2021.
The 2021 legislation allowed the last renewal until January 1, 2026 of the QPRI, short for Qualified Principal Residence Endetness. The exclusion also applies to debts canceled under written agreements entered into before January 1, 2026. This remains true even where an effective release occurs later.
What happens after the exclusion expires in early 2026, which happens to be an election year? Congress almost always renews “temporary” tax breaks, especially when they benefit struggling homeowners.
Amounts of exclusions. There are caps on the amounts remitted in connection with foreclosures or short sales. As of December 31, 2020, they were $750,000 for married couples filing jointly ($375,000 for single and married couples filing separately). Prior to December 31, 2020, the amounts were capped at $2 million and $1 million. For 2021 and subsequent years, the remittance over $750,000 (or $375,000) remains taxable.
Which exclusions pass the gathering and which do not? For the purposes of QPRI, or Qualified Principal Residence Indebtedness, a homeowner I will call Hester must meet two requirements in order to exclude (bypass) taxes.
First, the collateral for Hester’s mortgage must be her primary residence, meaning the place where she usually lives most of the year; the IRS also calls it his “principal residence”. Second, she must have incurred the debt to buy, build, or substantially improve that principal residence.
Also, the IRS prohibits relief when she obtains home equity loans or refinances, except to the extent that she used the proceeds to make improvements. The fine print also prohibits relief if lenders write off debts on vacation homes and other second homes or rental properties.
A qualifying primary residence. Whether a property qualifies as a principal residence depends on “all the circumstances” of each case. When, for example, Hester resides in more than one property, the IRS treats the property she uses the majority of the time during the year as her principal residence for that year.
It takes into account other factors. They include: his place of work; the principal place of residence of his family; the mailing address she uses on her tax returns, driver’s license, car registration and insurance, voter card, bills and correspondence; and the locations of religious organizations and country clubs with which it is affiliated.
While the IRS warns that Hester can only have one primary residence at a time, it is indifferent to the location of her primary residence. It’s okay if the locale is a county other than the United States.
QPRI. Section 108 only allows an exclusion for acquisition debts. As noted earlier, these are mortgages taken out by homeowners to purchase, build or substantially improve their principal residences or principal residences. And residences are used as guarantees for debts.
Section 108 also approves a limited exclusion for debt reduced by mortgage restructuring and for debt used to refinance QPRI. Here, there is relief only up to the amount of the old mortgage principal, just before the refinancing.
Another constraint to the exclusion: it does not help owners who take advantage of soaring real estate prices to make a “cash-out” refinancing, in which they have not used the funds for the renovation of their Principal residence. Instead, they used the funds to pay off credit card debt, tuition, medical bills, or some other expense.
This last category of prohibited expenses includes basic repairs that keep a home in good condition, but do not add to its value, extend its life or adapt it to new uses. For example, repainting a house, repairing gutters or floors, repairing leaks or plaster, or replacing broken windows.
Let’s say Hester bought a residence for $315,000, putting down a $15,000 down payment and taking out a $300,000 mortgage for which she was personally responsible and which was secured by the residence. The following year, Hester took out a second mortgage for $50,000 which she used to add a garage to her house.
When the home’s market value was $430,000 and the principal outstanding on her first and second mortgages was $325,000, Hester refinanced the two loans into one $400,000 loan. She used the additional debt of $75,000 (the amount by which the new $400,000 mortgage exceeded the $325,000 of the outstanding principal balances of the two loans immediately before the refinance) to pay off personal credit cards and pay her daughter’s school fees.
For exclusion purposes, Hester’s post-funding QPRI is only $325,000. Why? Because the $400,000 is only eligible for QPRI so long as it does not exceed the refinanced debt of $325,000.
And after. The second part will discuss other aspects of the exclusions for canceled or canceled debts in foreclosures or short sales.
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