New Mortgage Forgiveness Debt Relief Act of 2007

The new Mortgage Forgiveness Debt Relief Act of 2007 (the "Mortgage Relief Act") makes several welcome changes to the Internal Revenue Code to assist certain homeowners.

Exclusion of Gain

Under Section 7 of the Mortgage Relief Act, new widows and widowers can still exclude up to $500,000 in gain on the sale of their principal residence within two years after the death of their spouse. The gain on your principal residence is usually measured as the amount you receive for the sale of your property over your cost basis (what you paid for the house, as adjusted for certain capital improvements or as reduced by certain factors). Generally, if you are single, you can potentially exclude taxes up to $250,000 in gain from selling your principal residence. Married joint filers can exclude up to $500,000 in gain from selling their principal residence. Until 2008, if an individual were the surviving spouse, after the year in which his or her spouse died, the widow or widower could only exclude $250,000 in gain on the sale of the principal residence.

The two-year eligibility period for the larger exclusion begins on the date of the deceased spouse's death. Therefore, if your spouse dies on May 1, 2008 and you sell your house on April 30, 2010, you would still qualify for the larger $500,000 gain exclusion. However, if the sale did not take place until May 15, 2010, then more than 24 months would have passed since the date of your spouse's death, and you would not receive the larger $500,000 gain exclusion.

Limited Exclusion from Tax in the event of Relief from Debt

Another major benefit of the Mortgage Relief Act involves Cancellation of Debt (COD) income, which occurs when a lender forgives part or all of your mortgage debt. COD income is taxable in the year the debt is forgiven, unless a specific exclusion makes it tax-free. This creates significant issues for many homeowners who suddenly may face huge income tax bills if their lender forgives part or all of their debt. Section 2 of The Mortgage Relief Act retroactively creates a new exclusion for qualifying cancellations of home mortgage debt for the years 2007 through 2009. A homeowner can have up to $2 million of COD income from "qualified principal residence indebtedness," treated as “tax free.” Qualified principal residence indebtedness is debt that was used to acquire, build or improve your principal residence and that is secured by that residence. The basis (what you paid for the residence) of your principal residence is reduced by the excluded amount. Therefore, if your basis in your principal residence was $500,000, and your lender forgave $100,000 of the debt, your basis would be reduced to $400,000.

However, this exclusion is quite limited. It is not available to individuals in Title 11 bankruptcy cases. In addition, it does not apply to COD income from partial or total forgiveness of home equity loans used for purposes other than buying or fixing up your principal residence, such as paying off other debts. It also does not apply to COD income from partial or complete forgiveness of loans by lenders, on other real property, such as vacation homes.