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Tax Relief for "Phantom Income"

Written by on Tuesday, 17 July 2007 7:00 pm
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Many of the Realtors® who attended the recent mid-year meetings of the National Association of Realtors® (NAR) in Washington, DC, spent a considerable amount of time lobbying their legislators on behalf of various bills related to real estate. Prominent on their agenda was H.R. 1876, a bill that would provide tax relief for homeowners who have received "phantom income" as a result of forgiveness of mortgage debt. What the heck is that all about?

An anomalous situation may occur when a homeowner loses their home through a "short-sale" or a foreclosure. If the mortgage lender is willing to accept less than the balance that is due, the difference is treated as debt relief, which is taxable to the homeowner/borrower. Consider two examples.

  1. Bob and Carol purchased their home in 2005 for $400,000. They obtained 100 percent, interest-only, financing, and the balance is still $400,000. Now, the interest-only phase is over, and the loan has been recast at a higher interest rate with both principal and interest payments due. They can't afford the payments, and must sell. But now the property is only worth $380,000. They receive an offer for $380,000. The lender agrees to accept that amount, and takes a $20,000 loss.

  2. Ted and Alice bought a home for $450,000 at the same time. They put down 10 percent, and took out a mortgage of $405,000, which is still close to its original balance. Ted has lost his job and can't make the payments. Their house, too, has declined considerably in value. They are unable to sell. The lender forecloses, and the highest bid at auction, which the lender takes, is $385,000. Again, a $20,000 hit.

We haven't heard stories like that for some time. Unfortunately, they are becoming more common. What's also unfortunate, in cases like these examples, is that the homeowners have also incurred a tax obligation. In both cases the lender has accepted $20,000 less than was owed. It is true that in some states and in some situations, the lender might pursue the homeowner for the difference. That is generally unlikely, though, because the homeowner probably doesn't have much in the way of assets.

If a lender accepts less than the balance owed and cancels the debt, that amount is considered debt forgiveness; and tax is due on the amount forgiven. Hence the expression "phantom income."

There are generally legitimate reasons for taxing debt forgiveness. Without it, all sorts of tax dodges could prevail. Suppose the board of directors of MegaCorp wanted to give the CEO a big bonus, but he didn't want to have to pay tax on it. If debt forgiveness were not taxable, they could simply "loan" him the money, and then forgive the debt.

Some think that taxing mortgage debt forgiveness is appropriate, if the mortgage is the result of a cash-out refinance. Suppose I own a home that was originally purchased for $100,000 and is now worth $850,000. If I sold it, and were single, even with a $250,000 capital gain exclusion, I would still owe tax on the remaining $500,000. But, if I refinanced for $750,000 (or more), and then just let the property go to foreclosure, I would have all that money tax free, except for the fact that debt forgiveness is considered taxable income.

H.R. 1876 would provide tax relief on debt forgiveness for mortgage loans secured by a personal residence. In the case of a refinance loan, it would apply only up to the amount of the original purchase price (plus the cost of any improvements). The full amount of original purchase loans would be covered. The Realtors® have been lobbying on its behalf. If you think it is a good idea, you just might let your Congressperson know. That's how laws get passed. That's how things get changed.

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  About the author, Bob Hunt

Individual news stories are based upon the opinions of the writer and does not reflect the opinion of Realty Times.