Homeowners with forgiven loan debt get timely tax break

Dec 26, 2007

By Sandra Block, USA TODAY

Families who lost their homes to the foreclosure crisis this year will have at least one reason for cheer this holiday season: They won’t have to worry about a big tax bill.

Shortly before adjourning last week for the year, Congress approved a tax-relief bill designed to help families who had a portion of mortgage debt forgiven. Some families have had such debt forgiven through a foreclosure, a short sale or a loan restructuring that enabled them to stay in their homes. (In a short sale, a home is sold for less than the amount of the loan.)

Ordinarily, forgiven debt is treated as taxable income. In the past, families who lost homes because they couldn’t afford mortgage payments were sometimes stuck with a huge tax bill.

The tax "is a double whammy, and it’s kind of a surprise whammy," since most don’t realize that forgiven debt is taxable, says Mel Schwarz, partner at Grant Thornton’s national tax office.

The legislation is retroactive to Jan. 1, 2007. As a result, homeowners who had mortgage debt canceled this year won’t have to pay tax on it. The tax relief is scheduled to expire at the end of 2009, reflecting lawmakers’ belief that the subprime crisis "is a temporary problem so you only needed a temporary solution," Schwarz says.

President Bush on Thursday signed the bill, which also extends a tax deduction for private mortgage insurance through 2010.

Most home buyers who put less than 20% down on a home loan have to pay mortgage insurance. The insurance is designed to protect lenders in case of default. The cost is typically one-half of 1% of the home mortgage, or $75 a month for a $180,000 loan.

The full deduction is limited to homeowners with adjusted gross income of $100,000 or less; homeowners with AGI of up to $109,000 can take a partial deduction, says Glen Corso, senior vice president for PMI Group, a mortgage insurance provider.

The percentage of homeowners with private mortgage insurance rose sharply this year, reflecting tighter credit standards, says Kevin Schneider, president of Mortgage Insurance Companies of America, the trade association for mortgage insurers. Through the first three quarters of 2007, sales of private mortgage insurance rose 40% over the same period in 2006.

In the past, many homeowners who couldn’t afford a 20% down payment avoided mortgage insurance by taking out a "piggyback" mortgage. In a typical piggyback, a borrower gets a first mortgage for 80% of the value of the home, a second mortgage for 10% and pays 10% upfront. But tighter credit, and a sharp rise in delinquencies on second mortgages, Corso says, have made it much harder for home buyers to obtain a piggyback loan.

The deduction for private mortgage insurance is limited to mortgages issued after Dec. 31, 2006. Borrowers who are paying insurance on mortgages issued before that date aren’t eligible for the deduction.

Schneider estimates that 2.6 million homeowners will be able to claim the deduction on their 2007 taxes. The trade group projects that the tax break will save the average borrower $350 a year.

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