TAX CONSEQUENCES OF MORTGAGE MODIFICATIONS

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1 TAX CONSEQUENCES OF MORTGAGE MODIFICATIONS 1 Presenters: Jeff Gentes, Connecticut Fair Housing Center Elizabeth Maresca, Fordham Law School Diane E. Thompson, NCLC CANCELLATION OF DEBT - GENERAL RULES Gross income includes income from cancellation of debt (COD) (a.k.a. discharge of indebtedness (DOI)) IRC 61(a)(12) & Kirby Lumber (S. Ct. 1931) Loans are not income because of the corresponding obligation to repay The cancellation/discharge of the obligation to repay is income because the taxpayer has an increase in wealth due to the release 2 1

2 INCOME FROM CANCELLATION OF DEBT CAN ARISE IN VARIOUS CONTEXTS, INCLUDING: Cancellation of credit card debt Cancellation of automobile debt Cancellation of student loan debt Cancellation of home mortgage principal, with or without transfer of property (e.g., in a foreclosure or a loan modification or workout). 3 CANCELLATION OF RECOURSE DEBT AND GAIN/LOSS ON DISPOSITION Recourse debt in a foreclosure: gain or loss on the disposition AND potential COD income. Recourse debt in a loan modification: no disposition, but possibly COD income because of reduction in the principal amount of the loan. 4 2

3 CANCELLATION OF NONRECOURSE DEBT AND GAIN OR LOSS ON DISPOSITION Discharge of nonrecourse debt in a foreclosure, deed back, etc: gain or loss on disposition, but no COD income. Realization event occurs and amount realized is the full amount of the debt. Taxpayer has income / loss as per basis and amount realized Discharge of nonrecourse debt in a loan modification: COD income can arise. * See. Rev. Rul & Rev. Rul IRC 108(A) EXCLUSIONS FROM GROSS INCOME (1) IN GENERAL. Gross income does not include any amount which would be included in gross income by reasons of discharge of indebtedness of the taxpayer if (A) the discharge occurs in a title 11 case (bankruptcy), (B) the discharge occurs when the taxpayer is insolvent, (C) the indebtedness discharged is qualified farm indebtedness, (D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or (E) the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1,

4 STATUTORY EXCLUSIONS IRC 108 Detailed Explanations of the 3 following exclusions are discussed next 1. Bankruptcy 2. Insolvency 3. QPRI qualified principal residence indebtedness 7 BANKRUPTCY EXCLUSION IRC 108(A)(1)(A) Applies when a bankruptcy filing results in discharge and release of liability discharge MUST occur by Order of the bankruptcy court OR the discharge has to take place DURING the Court s jurisdiction Note, this subsection doesn t apply if you discharge the debt BEFORE you file for bankruptcy 8 4

5 INSOLVENCY EXCLUSION IRC 108(A)(1)(B) If the person is insolvent when the debt is cancelled, some or all of the income from COD may be excluded from gross income Insolvency exclusion is limited to amount of insolvency at the time of the cancellation of the debt at issue i.e. the amount excluded under IRC 108(a)(1)(B) shall not exceed the amount by which the taxpayer is insolvent Any amounts discharged in excess of insolvency, is generally taxable 9 DEFINITION OF INSOLVENCY IRC 108(D)(3) Insolvency is excess of liabilities over the FMV of assets immediately before the debt discharge The debt being discharged is included in the total liabilities of the taxpayer Assets include everything owned by taxpayer Including exempt assets Defined benefit plans are valued at FMV cash balance (value) in account * See, IRS Publ worksheet 10 5

6 INSOLVENCY WORKSHEET IRS, PUBLICATION INSOLVENCY WORKSHEET (CONT D) 12 6

7 QUALIFIED PRINCIPAL RESIDENCE INDEBTEDNESS IRC 108(A)(1)(E) & (H) excludes COD income from the discharge of QPRI after 1/1/2007 and before 1/1/2014 Applies to acquisition indebtedness as defined in IRC 163(h)(3)(B). $2 million limitation ($1 million for MFS) QPRI applies ONLY to principal residence as defined in IRC 121 (no 5 year look back for QPRI) Discharge must be directly related to decline in the value of the home or the taxpayer s financial condition 13 DEFINITION OF ACQUISITION INDEBTEDNESS IRC 163(H)(3)(B) Acquisition indebtedness is debt incurred in acquiring, constructing, or substantially improving the home and is secured by the home. May include refinanced debt and the proceeds of a home equity loan used to substantially improve the home; but does NOT include a home equity loan used to pay off credit cards, or purchase a car, pay medical bills, etc. 14 7

8 OTHER NON-STATUTORY EXCLUSIONS Disputed Debt Good faith dispute Disputed Credit cards Not my debt Unauthorized charges ID theft Debt isn t legally enforceable Casino marker that exceeds statutory limits Contested liability Except: Settlement of a liquidated debt is income In cases where the taxpayer acknowledged debt at all times; amount of credit card account debt was fixed Where dispute focused on repayment of the loan or correct terms of the loan and NOT about validity of loan there was income from the discharge 15 OTHER EXCLUSIONS Federal /state statutes regulating creditor s actions These give rise to legal arguments that debt: is disputed never existed (TILA / rescission) Not legally collectible Other state statutes Mortgage Modifications Unfair lending practices alleged by state AG which resulted in monetary settlement to home owners - no COD income See IRS CCA , 2011 WL (IRS CCA) 16 8

9 TRANSACTIONS NOT RESULTING IN COD INCOME Amounts otherwise excluded from income (e.g., gifts) Certain student loans IRC 108(f) Person works in a certain profession for a certain period of time Purchase price reduction by seller of property to solvent buyer IRC 108(e)(5) Deductible debt for cash basis taxpayers (e.g., interest on a qualified mortgage) 17 REDUCTION OF TAX ATTRIBUTES Reduction of tax attributes IRC 108(b) Basis reduction See IRC 1017 NOLs Business credits Minimum tax credit Capital loss carryovers Taxpayer can elect to reduce basis of depreciable property IRC 108(b)(5)(A) note personal assets such as a home are NOT depreciable These devices lead to the deferral of the recognition of income rather that the exclusion. 18 9

10 INFORMATION RETURNS Form 1099-A Acquisition or Abandonment of Secured Property Used in a foreclosure, deed back i.e. where title to property changes Form 1099-C Cancellation of Debt For any type of mortgage modification or other cancellation of debt 19 FORM 1099-A ACQUISITION OR ABANDONMENT OF SECURED PROPERTY 20 10

11 FORM 1099-A On Form 1099-A, the lender reports the amount of the debt owed (principal only), and the fair market value of the secured property From the Form 1099-A, the debtor uses these values to determine a gain or loss on the disposition of the property 21 FORM 1099-C CANCELLATION OF DEBT 22 11

12 FORM 1099-C On a Form 1099-C, the lender reports Taxpayer name, address and SSN Amount of cancelled debt The date of the cancellation The reason why the cancellation is being reported in this taxable year From a Form 1099-C, the debtor Should report the income Or the exclusion of the income on Form 982, if applicable Or the exclusion of the income on a statement attached to the tax return 23 INCORRECT INFORMATION REPORTED ON FORM 1099-A OR 1099-C IRS guidance will always direct taxpayer back to issuer to request a corrected Form When that doesn t work - i.e % of the times Taxpayer should report transaction correctly under the law and attach a statement or IRS Form (if applicable) explaining the discrepancy Taxpayers whould be proactive in reporting items that are included in a Form 1099 i.e. tell the IRS in the tax return why there is an exclusion, etc

13 AMENDING INCOME TAX RETURNS The statute of limitations for amending a tax return to request a refund is generally 3 years from the later of The due date of the return (individuals April 15 th ), or 2 years from the date the tax was paid Amended returns Used to make a change to original return Can be used to omit income improperly reported on original return and request refund Can be used to included income not included on original return and report additional taxes owed. 25 HELPFUL RESOURCES IRS Publication Canceled Debts, Foreclosures, Repossessions, and Abandonments (For Individuals), IRS Publication Sales and Other Dispositions of Assets - for detailed information on reporting gain or loss from repossession, foreclosure or abandonment of property. IRS Topic Canceled Debt Is It Taxable or Not? 26 13

14 HELPFUL RESOURCES CONTINUED IRS Form Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment). IRS Form Disclosure Statement IRS Publ Low Income Taxpayer Clinics 27 THE SPECIAL CASE OF HAMP PRINCIPAL REDUCTION MODIFICATIONS (GENERAL WELFARE PAYMENTS) Annual borrower incentive payments under HAMP (pay-forperformance) don t count as income IRS Rev. Rul Payments to the investors to encourage principal reductions, subsidize loan modifications, don t count as income. IRS Rev. Proc , at 14 Payments made to or on behalf of borrowers under the Hardest Hit programs don t count as income. IRS Notice , I.R.B

15 TIMING OF INCOME RECOGNITION UNDER HAMP HAMP mods spread out the reduction over 3 years Homeowners can recognize the income as forgiven or at the time the permanent modification goes into effect Most homeowners will minimize their tax consequences if they recognize the full amount of forgiven debt as income at the time the permanent modification is executed. Maximizes use of insolvency and QPRI Simplifies accounting and record-keeping Homeowners can amend prior returns Rev. Proc PRA INVESTOR INCENTIVES PRE-MARCH 2012 Months Past Due Incentive Payment Per MTMLTV First & Second Liens Before March 1, % to <115% 115% to 140% >140% 6 months > 6 months 6 cents on the dollar 30 15

16 PRA INVESTOR INCENTIVES FOR TPPS POST MARCH 1, 2012 Months Past Due Incentive Payment Per MTMLTV First Liens After March 1, % to <115% 115% to 140% >140% 6 months > 6 months 18 cents on the dollar Second Liens After June 1, 2012 <115% 115% to 140% >140% 6 months > 6 months 12 cents on the dollar 31 EXAMPLES 32 16

17 EXAMPLE 1 NON-HAMP MOD Single homeowner owes $180K House worth $100K Employment income of $40,000/year Offered modification with principal reduced to $115K Discharge of indebtedness = $65K 33 EXAMPLE 1 NON-HAMP MOD Homeowner could go from $40K to $105K in taxable income, and be subject to an additional $11,465 in taxes Do any exclusions apply? 1. QPRI 2. Insolvency 3. Bankruptcy 4. Disputed Debt 34 17

18 EXAMPLE 2 HAMP PRA Married homeowner owes $408,000 House worth $120,000 Employment income = $73,000/year Offered HAMP PRA in 2013 with: principal reduction opportunity of $90,000/year over 3 years (total of $270,000), down to $138,000 (115% LTV) $5,000 in additional good standing incentive 35 EXAMPLE 2 TAX CONSEQUENCES HAMP incentive payment to borrower excluded HAMP incentive payment to investor excluded But how much are the investor incentives? Depends on how far delinquent 36 18

19 EXAMPLE 2 HAMP PRA HOW MUCH ARE THE INVESTOR INCENTIVES? If more than six months delinquent: $270,000 x 18% = $48,600 If six months or less delinquent: $408,000 (UPB)/ $120,000 (current value) = 340% MTMLTV So, break it down into amount down to 140%, and amount between 140% and 115% $120,000 x 140%= $168,000 $ 408,000 - $168,000 = $240,000 (amount of principal reduction to reach 140%) $240,000 x 30% = $ 72,000 $30,000 (remaining principal reduction to reach 115%) * 45% = $13,500 Total investor incentives = $ 72,000 + $13,500 = $85, TAXABLE INCOME If loan more than six months delinquent $16,200 per year that can be excluded from income ($48,600/3) $90,000 - $16,200 = potentially taxable annual income of $73,800. $72,500 + $73,800 = $146,300, putting homeowner in 25% tax bracket Potential annual tax liability = $18,450, about ¼ of their wage income If loan less than or equal to six months delinquent: $28,500 per year that can be excluded from income $90,000 - $28,500 =$61,500 potentially taxable annual income 38 19

20 EXAMPLE 2 WHEN SHOULD THIS INCOME BE RECOGNIZED? Recognizing income over the next 3 years 2014, 2015, and 2016 and applying the exclusions that may exist each of those years versus Recognizing all the forgiveness in 2013 with the benefit of QPRI and, perhaps, existing insolvency 39 EXAMPLE 2: DO OTHER EXCLUSIONS APPLY? Timing considerations abound 1. QPRI? (if extended beyond 12/31/13) Was debt incurred reflective of acquisition and improvement costs (i.e., the basis in the home)? Let s say the basis were $350,000, with the rest attributable to cashout/pay-other-debt refinancing. 2. Insolvency? Depends on financial status in year of forgiveness 3. Bankruptcy? 4. Disputed Debt? 40 20

21 EXAMPLE 3 OCWEN SHARED APPRECIATION MOD Married homeowner owes $260K House worth $100K Homeowner makes $45,000/year Ocwen offers SAM: Principal is reduced by $165K to $95K over 3 years Rate of $55K forgiven each year If house is sold or refinanced, or at maturity, owner must give 25% of appreciation to Ocwen (house value at time of event less $95K) 41 EXAMPLE 3 TAX CONSEQUENCES No HAMP exclusions or elections Full amount of reduction is included in taxable income $55K additional taxable income/year Annual taxable income jumps from $45K to $100K Principal reduction taxed at 15% Approximately an additional tax liability of $8,000 per year for 2014, 2015,

22 EXAMPLE 3 EXCLUSIONS APPLY? 1. QPRI? (if extended beyond 12/31/13) Only helpful for years in effect Was debt incurred reflective of acquisition and improvement costs (i.e., the basis in the home)? Let s say the basis was $150,000, with the rest attributable to cashout/pay-other-debt refinancing 2. Insolvency? Depends on financial status at time of forgiveness Every year, on the anniversary date Value house every year Must do modification in the bankruptcy 3. Bankruptcy? Must do modification in the bankruptcy 4. Disputed Debt? 43 EXAMPLE 3 WHAT HAPPENS ON MATURITY, SALE, OR REFINANCING? House value rises to $195K at time of event Homeowner owes Ocwen $25K 25% * appreciation ($195K-$95K) Taxes on capital gains: If the homeowner excluded the principal reduction income, the basis is reduced: $150K-$165K= New basis is negative $15K But even so, this is less than capital gains exclusions What if homeowner paid taxes on that $25K? If less than 3 years, amend More than 3 years ago, mitigation provisions 44 22

23 EXAMPLE 4 Homeowner settles TILA rescission and $4,000 damages claims with a modification, and $26,000 in attorney fees. Debt financed: $250,000 Unpaid principal balance at time claims asserted: $245,000 Tender amount via modification: $220,000 Income from $25,000 reduction in debt? 45 EXCLUSIONS APPLY TO PRINCIPAL REDUCTION? Debt forgiven by operation of law? Disputed debt QPRI? Insolvency? Bankruptcy? 46 23

24 STATUTORY DAMAGES AND ATTORNEYS FEES? Damages taxable income Attorneys fees taxable income See other session 47 FOR MORE INFORMATION ON TAXES AND MORTGAGE MODIFICATIONS SEE NCLC S FORECLOSURE DEFENSE TREATISE Visit the NCLC Publications Exhibit Table To View and Order at Special Conference Discount 48 24

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