Mortgage Debt Forgiveness Tax Bill Sails Through House

Addressing the subprime lending crisis, the U.S. House of Representatives on Oct. 4 approved legislation that would eliminate any taxes home owners might face when banks renegotiate the terms of a home loan and forgive a portion of the outstanding mortgage debt. The change in the tax law would cap untaxable forgiven debt at $2 million and apply only to principal residences.
“This legislation will play a central role in helping American families avoid foreclosure and stay in their homes,” said NAHB President Brian Catalde.
Existing tax rules under Section 108 of the Internal Revenue Code impel many struggling home owners to seek foreclosure over restructuring their loan with lenders because forgiven mortgage debt is taxed as ordinary income.
H.R. 3648, the Mortgage Forgiveness Debt Relief Act of 2007, would remove this tax burden on mortgage indebtedness, encourage market-based restructuring between lenders and home owners and discourage foreclosures, said Catalde.
In a letter sent to all House members prior to consideration of the bill, NAHB designated the vote on final passage of H.R. 3648 as a “key vote” because of the importance of this issue to the nation’s home owners and housing industry.
“For families already struggling to make ends meet, the phantom income and resulting tax burden generated by Section 108 can endanger their financial health even further,” the NAHB letter said.
The legislation also follows one of the policy provisions approved at NAHB’s board of directors meeting last month in Seattle to address the mortgage credit crunch.
Deductibility of Mortgage Insurance Extended
H.R. 3648 also includes an NAHB-supported provision that extends the deductibility of mortgage insurance. Mortgage insurance is especially critical for low- and moderate-income first-time home buyers, many of whom may not qualify for a market-rate mortgage.
By enabling mortgage insurance premium payments to be deducted, NAHB said in its letter, “homeownership is made more affordable for thousands of families who would now be able to buy a home without having to resort to more costly subprime or predatory alternatives.”
The current deduction, which is set to expire on Dec. 31, would be extended through 2014 under the House bill.
Changes for Second Home Converted to Primary Residences
The debt-forgiveness plan to help strapped home owners would cost $2 billion over 10 years. To pay for this, the bill includes a provision that would change the tax laws that affect second homes converted to primary residences.
When Democrats regained control of Congress, they re-imposed pay-as-you-go rules requiring any loss in tax revenues to be offset by spending cuts or increases in revenue.
Under current law, a home owner can convert a second home into a principal residence for tax purposes if they have lived in the second home for at least two of the five years prior to the sale. In that case, the owner can exclude up to $250,000 in capital gains on the sale of the property, or up to $500,000 for married couples.
H.R. 3648 would alter those rules. Since the bill would provide a major benefit to housing by helping to stabilize the finances of thousands of American families who are facing default and prevent even more foreclosed homes from flooding the market, lawmakers also looked to the housing sector to pay for its cost.
NAHB Senior Officers and members of the association's Taxation Subcommittee and Federal Government Affairs Committee analyzed the legislation in depth, concluding that it was structured in such a way that the huge benefit on debt forgiveness and the extension for the deductibility of mortgage insurance outweighed the tax changes for second homes.
NAHB has worked closely with members of the House Ways and Means Committee to make this proposal as painless as possible to protect those with second homes. For example, NAHB was successful in helping to shepherd through a “grandfather” provision to allow most existing second home owners to live under the old rules.
The calculation for the new rules applies only to the period starting Jan. 1, 2008.
Under the bill, only a portion of the profit on a second home could be eligible for the primary residence capital gains exclusion. The formula is based on how long the owners lived in the home and how long they owned it.
For example, in general (putting aside the bill’s grandfathering rules), if a married couple owned a vacation home for 10 years and lived in it for two years, they would be eligible to receive a 20% exclusion on the capital gains when they sold the home — 20% because they were in the home two years out of 10. If the gain amount is equal to $100,000, $20,000 would not be subject to capital gains taxes.
Taking another example, if the same couple owned the vacation home for six years from 2008 to 2013 and lived in it for three years from 2010 to 2012, they could receive a 50% exclusion on capital gains. The 50% figure is derived from the fact that they lived in the home three out of the six years that they owned it. So if the couple were to receive a $100,000 gain on the sale of the home, they would get 50%, or $50,000, tax-free from the sale.
The bill would retain current rules that allow home owners to convert their second home into a principal residence for tax purposes if they have lived in it for two of the five years prior to the sale. The current limits on exclusion of capital gains tax would also apply — $250,000 for an individual or $500,000 for married couples.
Finally, to demonstrate the proposal’s grandfathering provision, a couple who purchased a vacation home in 2003 and lived in it for two of the five years prior to selling it in 2012 would be able to exclude 70% of their gains from taxation. The initial five years they owned the property — 2003 to 2007 — would be treated the same as years of residency since the bill’s provisions don’t take effect until 2008. Therefore, they would be able to claim residency for seven, or 70%, of the 10 years they owned the home. If they realized a $100,000 gain from the sale, then $70,000 would be excluded from taxation.
In determining residency rules, NAHB worked with lawmakers to ensure that the bill also contains other favorable safe harbors for second home owners — allowing exceptions for job losses, periods of absence and other emergencies.
To read the legislation, click here and enter H.R. 3648 in the box at the center of the page.
For more information, e-mail Greg Brown or Rob Dietz at NAHB, or call them at 800-368-5242 x8421 or x8285, respectively.