Mortgage Forgiveness in 'plain English'

New rules signed into law by President Bush a few weeks ago could help millions of homeowners -- and not just those facing foreclosure -- save thousands of dollars in taxes.

Q. I have heard some conflicting information about the bill that President Bush recently signed to help people who (like me) are struggling to pay their mortgage. Can you please explain the new law in "plain English"?

A. Sure. I have received several letters like yours, even before Bush signed the "Mortgage Forgiveness Debt Relief Act of 2007" into law Dec. 20.

The new law will affect millions of taxpayers, many of whom have had trouble making their loan payments, but also others who have not. It's a complicated piece of legislation, so I am devoting this entire column to answering some of the most common questions posed by readers.

For homeowners, the bill basically addresses three major issues that each involve the Internal Revenue Service: how the IRS treats taxpayers who get "debt forgiveness" from their lender; borrowers who must purchase private mortgage insurance to get a loan; and the way that home-sale profits are taxed on spouses who have recently lost a husband or wife.

Q. Under the new law, what will happen if I sell my home for less than I paid for it?

A. It depends on the circumstances surrounding the sale. But a cornerstone of the Debt Relief Act is a provision that eliminates the so-called "phantom tax" on many homeowners who lose money when a home is sold at foreclosure, voluntarily give their property back to the bank in order to avoid foreclosure proceedings or are lucky enough to get their lender to agree to restructure their loan in order to stay in their house.

For example, under previous law, a bank might agree to let a financially troubled borrower sell his home in a depressed market for $200,000 even though the outstanding balance of the mortgage was $250,000. Such a prearranged "short sale" would be good for the seller because he wouldn't have to pay the $50,000 shortfall back, and it also would help the bank because it wouldn't have to spend lots of time and money on foreclosure proceedings.

The problem was that the old IRS rules required the borrower to pay taxes on the $50,000 that the bank forgave. If the borrower was in a typical 28 percent tax bracket, he'd owe Uncle Sam $14,000 on the forgiven debt when April 15 came around and thus make his bad financial situation even worse.

Under the new law that Bush signed last month, most borrowers who received debt relief in 2007 from their bank -- or obtain such help this year or next -- won't have to pay taxes on it.

Q. Does the new law apply to rental property or vacation homes, too?

A. No. The act specifically states that the debt-forgiveness program only applies to a borrower's personal residence. Tax rules concerning rental properties and vacation homes basically remain the same.

Q. We purchased our home last May. Because we only had a 5 percent down payment, our bank also required us to purchase a private mortgage insurance (PMI) policy that cost us an extra $174 per month. The lender told us that we could deduct our PMI payments in 2007, but that the deductions would expire at the end of 2007 unless the deduction was extended by Congress. Does the new law address this issue?

A. Yes. Many lenders require buyers who make a down payment of less than 20 percent to purchase a private mortgage insurance policy as a requirement of getting a mortgage. The PMI reimburses the lender for some or all of its losses if the loan eventually goes into default.

About a year ago, Congress and the president finally passed a bill that allowed consumers who purchased new PMI policies to deduct the cost of such insurance -- but only for payments made through Dec. 31, 2007. The new debt-relief act extends such deductions through the end of 2010.

Q. The secretary at my seniors' center says she heard that the new law could help people like me, who recently lost their spouse. Is this true?

A. Yes. Under the new act, widows and widowers will now have up to two years from the time of their spouse's death to sell their longtime home and still keep up to $500,000 in home-sale profit tax-free.

Previously, taxpayers had to sell the home in the same year their spouse died to qualify for the $500,000 exclusion. If they waited any longer, they'd only be eligible for the $250,000 exclusion that is provided to single people.

This particular provision of the new law has been hailed by advocates for the elderly. They say that it will provide recently widowed but equity-rich owners with more time to properly grieve and also to think about their future housing options -- rather than rushing to make a quick sale in order to meet the IRS' previous guidelines.

Again, this new set of tax laws is complex. If you think that you might be affected by one of them, it's important to consult with an accountant or similar professional before you file your upcoming income-tax return.

© 2008, Cowles Syndicate Inc.