Order Code RL34212
Analysis of the Proposed Tax Exclusion for
Canceled Mortgage Debt Income
October 16, 2007
Pamela J. Jackson
Specialist in Public Finance
Government Finance Division
Erika Lunder
Legislative Attorney
American Law Division
Analysis of the Proposed Tax Exclusion for Canceled
Mortgage Debt Income
Summary
During 2007, the rate of foreclosures and mortgage defaults has been rising to
new levels. As lenders and borrowers work to resolve indebtedness issues, some
transactions are resulting in cancellation of debt. Mortgage debt cancellation can
occur when lenders restructure loans, reducing principal balances, or sell properties,
either in advance, or as a result, of foreclosure proceedings. If a lender forgives or
cancels such debt, current tax law treats it as cancellation of debt (COD) income
subject to tax. There are exceptions for taxpayers who are insolvent or in bankruptcy,
among others — these taxpayers may exclude canceled mortgage debt income under
existing law.
The Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648), which was
passed by the House by a vote of 386 to 27 on October 4, 2007, would exclude
canceled qualified residential debt from income. Thus, the act would allow
taxpayers who do not qualify for the existing exceptions to exclude canceled
mortgage debt income. The President has expressed support for the legislation
generally, but has stated a preference for a temporary tax provision — the bill’s
provision is permanent.
A rationale for excluding canceled mortgage debt income has focused on
minimizing hardship for households in distress. Policymakers have expressed
concern that households experiencing hardship and possibly losing their homes,
presumably as a result of financial distress, should not incur an additional hardship
by being taxed on canceled debt income. Some analysts have also drawn the
connection between minimizing hardship for individuals and consumer spending;
reductions in consumer spending, if significant, can lead to recession. Additionally,
legislators have been pursuing Federal Housing Authority (FHA) and government-
sponsored enterprise (GSE) reform efforts, in part to alleviate the current mortgage
crisis. As efforts to minimize the rate of foreclosure are being made, lenders are, in
some cases, renegotiating loans with borrowers to keep them in the home. For some
policymakers, the exclusion of canceled mortgage debt income may be a necessary
step to ensure that homeowner retention efforts are not thwarted by tax policy.
Opponents of an exclusion for canceled mortgage debt income might argue that
the provision would make debt forgiveness more attractive for homeowners relative
to current tax law and could encourage homeowners to be less responsible about
fulfilling debt obligations.
Congress may or may not choose to enact an exclusion for canceled mortgage
debt income. If this choice is made, the question arises as to whether an exclusion
should be granted for all homeowners. Alternatively, the exclusion could be limited.
Limits could be placed on such things as the amount of income excluded, the type of
households eligible to claim the exclusion, and the type of canceled debt eligible to
be excluded. Finally, the provision could be temporary rather than permanent.
This report will be updated in the event of significant legislative changes.
Contents
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Cancellation of Indebtedness Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Exceptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Gains From the Disposition of Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Legislative Developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
The Mortgage Forgiveness Debt Relief Act (110th Congress) . . . . . . . . . . . . 4
Selected Legislation in the 109th Congress . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Selected Proposals Made Prior to the 109th Congress . . . . . . . . . . . . . . . . . . 4
Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Homeownership Retention or Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Equity Among Homeowners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Past Enactments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Policy Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
What Kind of Exclusion? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
What Types of Canceled Debt? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Which Homeowners Should Be Eligible? . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Ownership Tenure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Household Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Should Basis Be Adjusted? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
List of Tables
Table 1. Current Tax Treatment of Canceled Debt Income Assuming
No Exclusions Apply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Table 2. Reported Canceled Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Analysis of the Proposed Tax Exclusion for
Canceled Mortgage Debt Income
Mortgage debt cancellation occurs when lenders engage in loss-mitigation
solutions that either (1) restructure the loan and reduce the principal balance or (2)
sell the property, either in advance, or as a result of foreclosure proceedings.1 Under
current law, the canceled debt (sometimes referred to as discharge of indebtedness)
may be income subject to taxation.
Proposals have been made to exclude canceled mortgage debt income from
taxation. The rationales for these proposals are to minimize hardship for households
in distress and to ensure that non-tax-related homeowner retention efforts are not
thwarted by tax policy. Critics could argue that the exclusion could encourage
homeowners to be less responsible about fulfilling debt obligations.2 In addition, the
exclusion would add to several housing subsidies provided in the tax code.
This report provides an overview and analysis of the current tax treatment of
canceled debt income, describes the proposal included in H.R. 3648, and concludes
with a discussion of policy options.
Overview
For federal income tax purposes, there are two types of income that may arise
when an individual’s mortgage is fully or partially canceled: cancellation of
indebtedness income and gain from the disposition of property.
1 In order to avoid foreclosure proceedings, lenders and homeowners may agree to “short
sell” properties or “deed-in-lieu” transactions. In short sales, the property is listed for sale
with the lender agreeing to take a reduced payoff on the outstanding loan amount. If the
property cannot easily be sold, the homeowner may give the lender the deed to the property
in lieu of foreclosure proceedings. The benefit of either option is that the homeowner does
not suffer the adverse credit impacts and possible stigma of foreclosure and the lender can
clear a non-performing loan without the associated costs of foreclosure, eviction, and
property rehabilitation.
2 Martin Vaughn, “Taxes - Panel Poised To Approve Forgiven Mortgage Debt Bill,”
CongressDaily, Sept. 26, 2007.
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Cancellation of Indebtedness Income
When all or part of a taxpayer’s debt is forgiven, the amount of the canceled
debt is ordinarily included in the taxpayer’s gross income.3 This income is typically
referred to as cancellation of debt (COD) income. The borrower will realize ordinary
income to the extent the canceled debt exceeds the value of any cash or property
given to the lender in exchange for cancelling the debt. Lenders report canceled debt
to the Internal Revenue Service (IRS) using Form 1099-C, and borrowers must
generally include the amount in gross income in the year of discharge.
Exceptions. Under current law, there are several exceptions to the general
rule that canceled debt is included in the gross income of the borrower. Section 108
of the Internal Revenue Code (IRC) contains two exceptions that are particularly
relevant in the case of canceled home mortgage debt: canceled debt is not included
in the borrower’s gross income if (1) it is discharged in Title 11 bankruptcy or (2) the
borrower is insolvent (that is, has liabilities that exceed the fair market value of his
or her assets, determined immediately prior to discharge).4
In the case of the bankruptcy exception, the debt must be discharged by the court
overseeing the bankruptcy proceedings or pursuant to a plan approved by that court.5
On the other hand, no involvement by a court is necessary for a taxpayer to claim an
insolvency exception — the taxpayer calculates his or her assets and liabilities and
then includes the information on tax returns filed with the IRS. For an insolvent
taxpayer, the amount of COD income that may be excluded is limited to the amount
by which the taxpayer is insolvent.6
For both the bankruptcy and insolvency exceptions, a taxpayer who excludes
canceled debt must essentially give back some of the benefit of the exclusion.
Specifically, the taxpayer must reduce certain beneficial tax attributes, including
basis in property, that would otherwise decrease the taxpayer’s income or tax liability
in future years.7 The attributes are reduced until the reductions generally account for
the excluded amount. As a result, the taxpayer may be subject to tax on the excluded
COD income in years following the year of discharge. Only when a taxpayer does
not have sufficient attributes to account for the entire excluded COD income is he or
she never subject to tax on that income.
In addition to the IRC § 108 exclusions, there are several other circumstances
under which COD income may be excluded. For example, a taxpayer with
3 See IRC § 61(a)(12); see also, U.S. v. Kirby Lumber Co., 284 U.S. 1 (1931)(holding, prior
to the IRC explicitly addressing the treatment of COD income, that a taxpayer had realized
income from the discharge of a debt).
4 See IRC § 108(a)(1)(A) and (B).
5 See IRC § 108(d)(2).
6 See IRC § 108(a)(3).
7 See IRC § 108(b). The taxpayer reduces basis in property in the order set out by Treasury
Regulation § 1.1017-1. Basis reduction occurs in the taxable year following the debt
discharge. See IRC § 1017(a).
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nonrecourse, as opposed to recourse, debt8 will not realize COD income.9 Other
examples of when COD income may be excluded from the borrower’s income are if
the cancellation was intended to be a gift10 or was the result of a disputed debt.11
Gains From the Disposition of Property
When an individual sells property, the excess of the sales price over the original
cost plus improvements (adjusted basis) is normally gain subject to tax.12 If the
property was held for more than 12 months, the gain is taxed at a maximum rate of
15% rather than the regular income tax rates. If the property was held for less than
12 months, the gain is taxed at the regular income tax rates.
In situations involving canceled home mortgage debt, if the lender takes the
home in exchange for the debt cancellation, the homeowner realizes gain from the
disposition of property in the amount that the property’s fair market value (or the
amount of outstanding debt, in the case of nonrecourse debt) exceeds the taxpayer’s
adjusted basis in the property.13 A taxpayer may have both gain from the disposition
of property and COD income.
IRC § 121 provides an exclusion for gain from the sale or disposition of a
personal residence. The provision excludes gain of up to $250,000 for single
taxpayers and $500,000 for married couples filing joint returns if the taxpayer meets
a use test (has used the house as the principal residence for at least two of the last five
years) and an ownership test (has owned the house for at least two of the last five
years). A taxpayer who does not meet the qualifications may be eligible for a partial
exclusion if the home was sold because of a change in employment or health or due
to unforeseen circumstances.14 Additionally, other taxpayers may qualify for special
treatment (e.g., members of the armed forces).15 The exclusion can generally be used
every two years.
8 Recourse debt is debt for which the borrower is personally liable if he or she defaults on
the loan. Nonrecourse debt is secured by property, and the borrower is not personally liable
for the debt; if he or she defaults on the loan, the lender’s only remedy is to seize the
property.
9 For more information, see U.S. Department of the Treasury, Internal Revenue Service,
Questions and Answers on Home Foreclosure and Debt Cancellation, available at
[http://www.irs.gov/newsroom/article/0,,id=174034,00.html].
10 See IRC § 102.
11 See Zarin v. Comm’r, 916 F.2d 110, 115 (3rd Cir. 1990).
12 See IRC §§ 61(a)(3) and 1001.
13 For more information, see U.S. Department of the Treasury, Internal Revenue Service,
Questions and Answers on Home Foreclosure and Debt Cancellation, available at
[http://www.irs.gov/newsroom/article/0,,id=174034,00.html].
14 See IRC § 121(c).
15 See IRC § 121(d)(9).
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Legislative Developments
The Mortgage Forgiveness Debt Relief Act (110th Congress)
The Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) was passed by
the House on October 4, 2007, by a vote of 386 to 27. The act would, among other
things, exclude discharged qualified residential debt from gross income. Qualified
indebtedness would be debt, limited to $2 million ($1 million if married filing
separately), incurred in acquiring, constructing, or substantially improving the
taxpayer’s principal residence that is secured by such residence. It would also
include refinancing of this debt, to the extent that the refinancing does not exceed the
amount of refinanced indebtedness. The taxpayer would be required to reduce the
basis in the principal residence by the amount of the excluded income. The provision
would not apply if the discharge was on account of services performed for the lender
or any other factor not directly related to a decline in the residence’s value or to the
taxpayer’s financial condition. The provision would apply to debt discharges that are
made on or after January 1, 2007. The provision has been estimated to cost $1.34
billion in reduced tax revenue from FY2008 through FY2017.16
The President has stated general support for an exclusion of canceled residential
debt income, but supports a temporary provision rather than the permanent relief
proposed in H.R. 3648.17
Selected Legislation in the 109th Congress
Debt cancellation relief was enacted by the Katrina Emergency Tax Relief Act
of 2005 (KETRA; P.L. 109-73), which became law in September 2005. That
legislation contained temporary tax relief provisions intended to directly and
indirectly assist individuals in recovering from the devastation of Hurricane
Katrina.18 Included in KETRA was a temporary exclusion for non-business debt that
was forgiven by a governmental agency or certain financial institutions. If the
discharge occurred between August 24, 2005, and January 1, 2007, eligible
individuals (e.g., those with their principal place of abode on August 25, 2005, in the
core disaster area) were able to exclude the COD income.
Selected Proposals Made Prior to the 109th Congress
A provision enacted in the Tax Reform Act of 1986 (P.L. 99-514, § 405) allows
farmers who are solvent to treat certain COD income as if the farmer were insolvent.
Essentially, discharged, qualified farm debt is excluded from taxation if canceled by
16 U.S. Congress, Joint Committee on Taxation, Estimated Revenue Effects of H.R. 3648,
JCX-98-07, Oct. 5, 2007.
17 U.S. President (Bush), “Fact Sheet: New Steps to Help Homeowners Avoid Foreclosure,”
website [http://www.whitehouse.gov/infocus/economy/] visited Oct. 4, 2007.
18 For more information, see CRS Report RS22269, Katrina Emergency Tax Relief Act of
2005, by Erika Lunder.
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a qualified person. This debt relief is not exclusively mortgage related but has to
have been incurred directly from the operation of a farming business.
In the past, Congress has provided tax relief when mortgage debt is forgiven.
In August 1993, the Omnibus Budget Reconciliation Act (P.L. 103-66, § 13150)
enacted a provision for permanent tax relief to owners of commercial real estate
when some portion of the debt on commercial and investment property was forgiven.
At that time, the conference committee stated the following:
The committee understands that real property has declined in value in some areas
of the nation, in some cases to such a degree that the property can no longer
support the debt with which it is encumbered. The committee believes that where
an individual has discharge of indebtedness that results from a decline in value
of business real property securing that indebtedness, it is appropriate to provide
for deferral, rather than current inclusion, of the resulting income. Generally, that
deferral should not extend beyond the period that the taxpayer owns the
property.19
In 1999 and 2000, the House and Senate, respectively, each passed a tax bill that
provided tax relief for mortgage cancellation, but neither bill was enacted. During
that time period, several regional markets had experienced severe housing slumps
and falling property values. In subsequent years that legislation was reintroduced
(H.R. 666 in the 108th Congress; H.R. 3458 in the 109th Congress).
Analysis
In order to evaluate the policy of including discharged debt as income, it is
helpful to understand how it works. According to economic theory, one way of
defining income is as the change (over the period in question) in a person’s net worth
— that is, the change in the value of the person’s assets minus the change in their
liabilities. By this definition, a forgiven loan is income: a canceled debt reduces a
taxpayer’s liabilities, and thus increases net worth. Current tax law generally adheres
to this concept by providing that if the obligation to repay the lender is forgiven, the
amount of loan proceeds that is forgiven is reportable income subject to tax.20
This portion of the report provides analysis of the issues associated with the tax
treatment of canceled mortgage debt income.
Homeownership Retention or Loss
In some instances, lenders may restructure or rearrange debt, cancel some debt,
and allow the homeowner to retain ownership of the home. Then, all other things
19 U.S. Congress, House Committee on the Budget, Omnibus Budget Reconciliation Act of
1993, H.Rept. 103-111, May 25, 1993.
20 This tax treatment applies to many different kinds of debt, such as auto loans and credit
cards, in addition to mortgage debt. As mentioned previously, if taxpayers are insolvent or
bankrupt, they are fully or partially exempt from taxation on the canceled debt.
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being equal, the borrower’s net worth has increased as liabilities have declined and
assets have remained unchanged. Alternatively, homeowners may experience debt
cancellation while losing their home, through foreclosure or as a result of voluntarily
deeding the property back to the lender. Tax law treats the loss of the home in this
situation as a disposition of property that gives rise to gain or loss. The homeowner
no longer has the asset and, to the extent the asset value exceeded liabilities, may be
worse off as a result of declining net worth. Additionally, he or she may realize gains
or losses, which may make the taxpayer better or worse off as well.
The current tax treatment of COD income, assuming equal amounts of canceled
debt, is the same regardless of whether the home is retained or lost. An illustration
is shown in Table 1. Assuming residential debt of $200,000, a loan restructuring
could occur, after which the homeowner owes $180,000 and the lender has agreed
to cancel the remaining amount. The discharged debt, $20,000, is income subject to
tax if no exclusion applies (e.g., the taxpayer is not insolvent) — if a rate of 28% is
assumed, the tax liability is $5,600. Alternatively, the home could have been sold as
a result of foreclosure with a sales price of $180,000 along with a lender agreement
to cancel the remaining debt. The $20,000 discharge is income and, assuming no
exclusion applies and the same tax rate, generates the same tax liability. This is in
addition to any taxes the taxpayer may owe on the gain from the sale of the house.
Table 1. Current Tax Treatment of Canceled Debt Income
Assuming No Exclusions Apply
Qualified residential debt
$200,000
Loan is renegotiated or property disposed of
($180,000)
Remaining balance of debt , which is forgiven
$20,000
Tax liability (assume 28% rate)
$5,600
on canceled debt of $20,000
Source: CRS
If current law was amended to exclude such COD income, then the $20,000
discharge would not be included in gross income and the taxpayer would not owe the
$5,600 tax liability. If, as in H.R. 3648, taxpayers had to account for the excluded
COD income by reducing basis in the residence, the impact of such adjustment could
differ, depending on whether the home is lost or retained, for the taxpayers who owe
taxes on the gain from disposing of the house. If such a taxpayer loses the house, the
tax consequences would depend on the timing of the basis adjustment. If basis was
reduced in the year following discharge, as under current law, then the excluded
COD income would not be accounted for because the residence was disposed of prior
to the required basis adjustment. If basis was reduced prior to disposition (e.g., at the
time of discharge), then the excluded COD income would be accounted for. For
homeowners with taxable gain who retain the house and sell it in a later year, the
basis would be adjusted by the time of the sale to account for the excluded income,
but the taxes owed on the disposition would be deferred until that time. Thus, the
taxpayer who retains the house would be better off than a similarly situated taxpayer
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who loses it and was taxed on the same gain in the year of discharge.21 However, as
noted, it is possible, depending on the timing of the basis adjustment, that the
homeowner losing the house would not account for the excluded COD income.
Equity Among Homeowners
An exclusion of income can result in individuals with identical incomes paying
different amounts of tax. A standard of fairness frequently invoked by public finance
analysts in evaluating tax policy is “horizontal equity” — a standard that is met when
persons with identical incomes pay the same amount of tax. Like other exclusions,
an exclusion for debt forgiveness would violate the standard of horizontal equity.
Specifically, a person who has no forgiven debt might pay more taxes than a person
who has the same amount of income, a part of which constitutes canceled debt.
An exclusion of forgiven debt may also reduce the tax system’s progressivity
— the proposed provision, in other words, would likely favor upper-income
individuals. This would occur because an exclusion of a given amount is more
valuable to persons with higher marginal tax rates. This effect would be magnified
if homeownership is more concentrated among upper income individuals.
An example of the effect an income tax exclusion has on the tax system’s
progressivity can be seen by identifying two individual homeowners, both of whom
incur $20,000 in COD income. The tax benefit to the two differs if they are in
different tax brackets.22 The value of the exclusion for a homeowner with lower
income, who may be in the 15% income tax bracket, is $3,000, while the value to
another homeowner, with higher income in the 28% bracket, is $5,600. Thus, the
higher income taxpayer, with presumably greater ability to pay taxes, receives a
greater tax benefit than the lower income taxpayer.
Past Enactments
Over the past quarter century, Congress has enacted tax relief for canceled debt
in several instances, including assisting Hurricane Katrina victims in 2005 and
commercial property owners and farmers during economic downturns in 1986 and
1993. The 2005 legislation was temporary while the others were permanent.
It could be argued that the market conditions that led to the 1986 and 1993
congressional enactments also exist today. Specifically, property values may be
declining such that the property no longer supports the debt with which it is
encumbered. Currently, the policy issue is posed by residential housing; in 1986, the
problem was the business property of farmers; and in 1993, the issue was business
real property. In providing the 1993 exclusion, Congress acknowledged it was
21 The time value of money asserts that the present value of a certain amount of money is
greater than the future value of that same amount. Thus, the cost of a tax payment of $5,600
today is more than the same amount paid in the future.
22 COD income may cause a taxpayer to move to a higher tax bracket.
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essentially allowing the taxpayer to defer the income subject to tax because an
adjustment to basis was required.23
The 1986 exclusion of COD income for farmers may provide the most relevant
reference for analysis of the current issues. At the enactment of the exclusion,
Congress was concerned that pending legislation providing Federal guarantees
for lenders participating in farm-loan write-downs would cause some farmers to
recognize large amounts of income when farm loans were canceled. As a result,
these farmers might be forced to sell their farmland to pay the taxes on the
canceled debt. This tax provision was adopted to mitigate that problem.24
Consistent with the 1986 enactment, one rationale expressed for the current
proposed exclusion of canceled residential debt income is to prevent unintended
adverse consequences resulting from foreclosure prevention efforts. Specifically, as
lenders are being encouraged to write-down, or work out, loans with distressed
borrowers, these efforts could be diminished by the income taxation of canceled debt.
Data
Lenders report canceled debt income on IRS Form 1099-C. The data reported
include all types of debt, not just residential. As shown in Table 2, the number of
Forms 1099-C filed rose by 112% from 2003 through 2007. The amount of canceled
debt also increased from 2003 to 2004, although data for subsequent years are not
available. While specific conclusions about mortgage debt cancellation cannot be
drawn from these data, to the extent that debt cancellation represents financial
distress, the data suggest that the number of financially distressed taxpayers might
be increasing. Alternatively, the rise in debt cancellations may be associated with
increases in the number of debt transactions. In this case, the number of debt
cancellations as a portion of debt may be proportionally the same.
23 U.S. Congress, House Committee on the Budget, Omnibus Budget Reconciliation Act of
1993, H.Rept. 103-111, May 25, 1993.
24 U.S. Senate Committee on the Budget, Tax Expenditures: Compendium of Background
Material on Individual Provisions, S. Prt. 109-072, 109th Cong., 2nd sess., p. 220.
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Table 2. Reported Canceled Debt
Amount of Debt Claimed
Tax Year
Number of Forms
($1,000)
2003
968,991
$6,229,584
2004
1,048,284
$7,144,087
2005
1,369,459*
na
2006
1,942,694*
na
2007
2,058,600*
na
Source: U.S. Department of the Treasury, Internal Revenue Service, Statistics of Income Division,
reported on Sept. 17, 2007.
Note: The 2005, 2006, and 2007 data are projections.
Policy Options
Congress may choose not to alter the current tax law as it pertains to canceled
debt income; in this case, no legislative action is required.25 If the treatment remains
unaltered, canceled mortgage debt income is subject to tax unless the taxpayer meets
an exception to the provision (e.g., the taxpayer is insolvent).
In lieu of legislative changes, improving awareness about the existing exclusions
that apply when there is canceled debt, such as for insolvency or bankruptcy, may be
an option to pursue. Also, it may be important to ensure that taxpayers know what
to do if lenders misreport information on the Form 1099-C, which could make it
appear that the taxpayer has canceled debt income that has not actually occurred.
Congress may choose to enact an exclusion for canceled mortgage debt income.
As discussed above, existing law provides an exclusion of COD income for, among
others, taxpayers who are insolvent or in bankruptcy. A proposal to exclude
residential COD income would apply to taxpayers who do not currently qualify for
exclusion because, for example, they are solvent.
An exclusion for canceled mortgage debt income would have different impacts
on taxpayers, depending on a variety of circumstances. If an exclusion is pursued,
several choices about the level of detail in the policy may be explored. The choices
about the provision may depend on its purpose. One stated purpose is to minimize
hardship for households in distress. Another stated purpose is to eliminate the
adverse consequence of a tax for those homeowners able to renegotiate loans with
their lenders, thus, to some extent, encouraging loan forgiveness, rather than
foreclosure.
The potential minimization of hardship for financially distressed households has
another, broader relevance. In the wake of foreclosures and housing market
25 Unlike appropriations, tax provisions do not require reauthorization.
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disruptions, financial distress to households could reduce consumer spending. A
decline in consumer spending could cause or contribute to a recession. While an
exclusion of residential COD income cannot prevent a recession, it might minimize
financial distress for borrowers and contribute to minimizing adverse consequences
vis-a-vis consumer spending.
What Kind of Exclusion?
One consideration for Congress is whether an exclusion provision should be
temporary or permanent. As noted earlier, H.R. 3648 proposes permanence, whereas
the Administration has suggested the provision should be temporary.
The current treatment of canceled debt income has existed in tax law for
decades. Some argue that current housing market conditions, where there are a large
number of “upside down” (the debt owed on the property exceeds the value of the
property) homeowners, warrant a temporary solution for a crisis that is not expected
to last. If the primary purpose of the policy is to minimize adverse consequences
associated with loan renegotiations in the short-term (and minimize any potential
economic downturn associated with housing market problems), then a temporary
measure seems consistent with these purposes.
It could be argued that a provision providing for the exclusion of residential
COD income should be temporary because owner-occupied housing is heavily
subsidized even without a COD income exclusion. There are three principal tax
provisions for owner-occupied housing currently in the tax code. The deduction for
mortgage interest is the most costly provision, with an estimate of $85.2 billion in
revenue loss for FY2008.26 The exclusion of gain on the sales of homes is the second
largest tax provision for homeowners, with an estimate of $30.1 billion in tax
revenue loss for FY2008.27 The deduction of state and local real estate taxes is the
third provision, with an estimate of $14.2 billion in tax revenue loss for FY2008.28
Some economists feel that this preferential tax treatment encourages households to
overinvest in housing and less in business investments that might contribute more to
increasing the nation’s productivity and output.29
On the other hand, some analysts might argue that the provision should be
permanent. A case could be made that a temporary provision is unfair because there
is no difference between an individual experiencing canceled debt income in 2007,
when foreclosure rates may be high, relative to three or four years from now, when
foreclosure rates may be lower. If the policy purpose is to minimize hardship when
taxpayers experience distress, then making the provision permanent would seem
consistent with that purpose.
26 U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for
Fiscal Years 2007 to 2011, JCS-3-07 (Washington: GPO, 2007), p. 27.
27 Ibid.
28 Ibid.
29 N. Edward Coulson, “Housing Policy and the Social Benefits of Homeownership,”
Business Review - Federal Reserve Bank of Philadelphia, Second Quarter 2002, p. 8.
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What Types of Canceled Debt?
Several options are possible in determining what type of canceled mortgage debt
income may be excluded from taxation. All canceled residential debt could be
excluded from income, or alternatively, only certain kinds of debt could be allowed.
H.R. 3648 proposes to limit the provision to debt associated with the primary
residence of a taxpayer, rather than, for instance, a vacation home or investment
property.
Some policy analysts have suggested disallowing second liens as qualified
residential debt. The legislation proposed does not include a restriction against
second liens. H.R. 3648, however, restricts qualified debt to include debt incurred in
acquiring, constructing, or substantially improving the taxpayer’s principal residence.
For some individuals, second liens may be home equity lines of credit, for
others, second liens may be debt incurred as part of the purchase of the home. To the
extent that home equity lines of credit are used to enhance the home and make capital
improvements, it may be consistent with stated policy goals to include this debt as
eligible for the exclusion. Yet, home equity lines of credit can also be used to
finance consumption, such as vacations or paying off other debt. It may not be
consistent with policy goals, some might argue, to include this type of debt in the
exclusion.
Congress may also wish to consider limiting the amount of canceled debt that
is excluded from income. As in the case of capital gains exclusion on sales of
primary residences, a ceiling amount may be designated, such that any COD income
below that level is excluded and COD income above that level is taxed. H.R. 3648
limits excluded COD income to $2 million ($1 million if married filing separate
returns).
This option could reduce the amount of income excluded from taxation and thus
limit the revenue loss associated with enacting an exclusion. The restriction might
also reduce the benefit to upper income taxpayers. Limiting the amount of canceled
debt income excluded would increase, albeit perhaps only slightly, complexity for tax
filers and for tax administration, but would be unlikely to alter the reporting
requirements of lenders.
Which Homeowners Should Be Eligible?
Policy makers would need to decide whether to exclude canceled debt income
for all households or only some.
Ownership Tenure. As with the exclusion for gain on owner-occupied
housing, the exclusion for canceled debt income could be limited to homeowners
who meet certain ownership tests. As mentioned previously, taxpayers must meet
both an ownership and a tenure test to be eligible to claim the exclusion for gain
under IRC § 121. Taxpayers are eligible if they have met the use test (have lived in
the house for at least two years out of the last five years) and the ownership test (have
owned the house, also for two years out of the last five). Limiting the exclusion of
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capital gains in this manner was designed to minimize the possibility that investors,
rather than owner-occupants, would be able to exclude capital gains from taxation.
Alternatively, it could be argued that in the case of mortgage debt cancellation, tenure
is not relevant to the stated policy goals for the legislation.
If this kind of restriction were applied to an exclusion of COD income, the
number of tax filers eligible to claim the exclusion might be reduced. This reduction
in filers may result in lower revenue loss. This policy option would add complexity
to the reporting and filing processes and thus the tax code.
Household Income. Some policy makers have suggested that foreclosure
assistance be provided only to households with low and moderate incomes. As with
other housing tax incentives, such as the mortgage revenue bond program and the
first-time homebuyer tax credit for District of Columbia residents, income levels
could be capped and the exclusion made unavailable to those households with
income above the ceiling set by the legislation. It would seem that income would be
highly correlated with foreclosure, in that those with lower income are experiencing
hardship. Regardless of whether this is borne out by the data, it could be argued that
household income is not relevant to the stated policy goals for the legislation.
This option could reduce the revenue loss associated with the provision, but
would add complexity to the administration and tax filing process, relative to an
exclusion without such a restriction.
Should Basis Be Adjusted?
As discussed above, current law requires that taxpayers who exclude COD
income must essentially give back some of benefit by reducing tax attributes, such
as basis in property. As a result of the reduction, taxpayers increase their income or
tax liability in later years to account for the excluded COD income, so that only
taxpayers without sufficient attributes to account for the entire amount are not taxed
on it. Several policy issues arise from this rule.
The first is which tax attributes, if any, should be adjusted to account for
excluded canceled mortgage debt income. One option is that there be no attribute
reduction requirement. Alternatively, homeowners could be required to reduce
specified tax attributes that include, but are not limited to, basis in the principal
residence (e.g., taxpayers would be able to reduce basis in property other than the
home subject to the discharged mortgage). A third option would be to require basis
reduction in the taxpayer’s principal residence. All taxpayers would benefit from the
first option by not having to account for the excluded COD income. Whether a
taxpayer would prefer the second option over the third one would depend on his or
her circumstances (e.g., whether the taxpayer has basis in other property that would
have to be reduced in the event of insufficient basis in the residence). H.R. 3648 uses
the third option — it would require the homeowner to reduce basis in the principal
residence to account for the excluded COD income.
Another issue is when tax attributes should be adjusted. If basis is adjusted, one
option could be to make the proposal consistent with current law, under which basis
adjustment occurs in the year following discharge of the debt. Alternatively, basis
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adjustment could occur at the time of discharge or exclusion. If basis adjustment
occurred in the year after discharge, homeowners losing their home at the time of
debt cancellation would have already disposed of the property. H.R. 3648 does not
explicitly address timing.
The restriction in H.R. 3468 requiring basis adjustment by the amount of
cancelled debt suggests a desire by policymakers for homeowners to have to account
for the benefit of the cancelled debt. Basis adjustment results in the taxation of
cancelled debt income to the extent that gain from the disposition of the home is
taxable; however, the timing of the basis adjustment may result in different tax
consequences for taxpayers who lose their home.
The exclusion of COD income may result in differential treatment of taxpayers
depending on the circumstances of basis adjustment timing, eligibility for exclusion
of gain from the disposition of the residence, and homeownership retention.
Policymakers may wish to account for that differential treatment, although doing so
may add complexity and administrative cost to the proposal relative to its current
state.
Conclusion
H.R. 3648 (the Mortgage Debt Forgiveness Relief Act of 2007), which was
passed by the House on October 4, 2007, would exclude qualified canceled
residential debt from taxation. This bill may help to accomplish the policy goals of
minimizing hardship in the event of foreclosures and ensuring homeownership
retention efforts are not thwarted by tax policy. Additional limitations could be
imposed to restrict the exclusion. In doing so, the revenue loss resulting from the bill
could be reduced, though certain restrictions may be inconsistent with the policy
goals.
The exclusion of COD income may make debt forgiveness more attractive for
homeowners relative to the current tax law. Some might argue, therefore, that this
proposal could encourage homeowners to be less responsible about fulfilling debt
obligations. These opponents might argue that the current exclusion available for
those homeowners filing bankruptcy or claiming insolvency is sufficient. Another
argument that could be made opposing the provision is that homeownership is
already heavily subsidized.30
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30 As mentioned earlier in this report, the current tax subsidies for homeownership are
estimated to cost nearly $130 billion.