The Internal Revenue Service announced this week procedures designed to aid as many homeowners as possible who are facing the year-end expiration of a tax provision that excludes from income mortgage debt forgiven in connection with the Principal Reduction Modification Program (PRMP) and the Home Affordable Modification Program (HAMP).
The Good News. The IRS notice offers clarity and assurance to homeowner-borrowers that if they are in the trial period of the PRMP or HAMP programs, or will enter into the trial period before the end of 2016, even if the debt reduction does not occur until 2017, the tax relief provisions of the expiring provision will apply to them if the conditions outlined are met.
The IRS announcement (Notice 2016-72) provides that IRS will consider the debt forgiveness to occur before the December 31, 2016 deadline for tax-free treatment as long as the following conditions are met:
- An arrangement under PRMP or HAMP is entered into in writing before January 1, 2017;
- Before that date, a mortgage loan servicer sends the borrow-homeowner a notice outlining the terms and conditions of the permanent mortgage loan reduction that will occur following the successful completion of the trial period.
Background. In order to help distressed homeowners to lower their month mortgage payments, the Federal Housing Finance Agency (FHFA) directed Fannie Mae and Freddie Mac to implement PRMP and HAMP. These programs lower mortgage balances and payments for certain seriously delinquent borrowers who owe more on their mortgage loans than their homes are worth. The mortgage reduction typically occurs after a three-month trial period, during which the homeowner-borrower must meet certain conditions.
The Problem. Under the general rules of the U.S. tax law, forgiven debt is taxable income to the borrower. However, a temporary provision in the law, available since 2007, provides that mortgage debt used to buy, build, or improve a principal residence can be forgiven tax-free. But this provision is set to expire on December 31, 2016. Therefore, mortgage debt forgiven after this date will be considered taxable income to the borrower. For homeowner-borrowers entering into a trial period under PRMP or HAMP toward the end of 2016, the question of when the loan forgiveness occurs is thus critical. If the mortgage balance reduction is considered to occur in 2016, there is generally no tax due on the forgiveness. However, if the loan reduction is deemed to happen in 2017, tax could be assessed on the arrangement.