Compliance Bulletin

Consumer Confusion Over Debt Cancellation Relief
March 15, 2010

Congress enacted the Mortgage Forgiveness Debt Relief Act of 2007 (“2007 Act”) in order to give federal tax relief to individuals who have had residential mortgage debt cancelled or forgiven by a lender and who otherwise would be subject to income tax on the cancelled amount. Recently, some consumers who have had their residential mortgage debt cancelled have vocally complained that financial institutions are improperly completing Form 1099C (Cancellation of Debt) by checking on box #5 indicating that the borrower is personally liable on the debt. This is the form that financial institutions are required to furnish to borrowers when they cancel any form of debt of $600 or more, including debt to acquire a principal residence (as discussed below). The consumers, who formed a Facebook group and have aired their grievances to state legislators, believe erroneously that this designation jeopardizes their tax exclusion under the 2007 Act. The purpose of this Bulletin is to summarize the state of the law and to provide lenders with resources to respond effectively to concerned borrowers.

Normally, cancellation of debt is treated as taxable ordinary income if the taxpayer is personally liable on the debt. If the taxpayer is not personally liable, the cancelled amount is not treated as ordinary income under the rationale that no benefit has been conferred to the taxpayer, unless the lender offers a discount for the early payment of the debt or agrees to a loan modification that results in the reduction of the principal balance of the debt. Upon the disposition of property securing a nonrecourse debt, the amount realized includes the entire unpaid amount of the debt. As a result the taxpayer may realize a gain or loss if the outstanding debt differs from the taxpayer’s basis. See IRS Publication 4681.

The Internal Revenue Code recognizes several exceptions to this rule of imputed income. The 2007 Act creates an exclusion from income of “qualified principal residence indebtedness” discharged before January 1, 2010, and the Emergency Economic Stabilization Act of 2008 extended the exclusion to debts discharged before January 1, 2013. California enacted SB 1055 in 2008 to partially conform state tax law with the 2007 Act, as amended, but that bill applied only to qualified indebtedness discharged as of January 1, 2007 and before January 1, 2009. Currently, there are bills being considered by the California legislature that would, among other things, extend the date to January 1, 2013 [1].

“Qualified principal residence indebtedness” means the same as “acquisition indebtedness” defined in 26 U.S.C. Section 163(h)(3)(B), which is debt incurred to acquire, construct, or substantially improve the borrower’s principal residence and the debt is secured by the residence. The term includes any refinance of such debt but excludes any amounts in excess of the acquisition indebtedness. See 26 U.S.C. Section 108(h)(2).

As suggested above, the consumers’ concerns are misplaced. The exclusion applies if the cancelled debt is recourse, not non-recourse, and checking the “personally liable” box indicates the exclusion applies. On the other hand, if the lender indicated that the borrower is not personally liable on the residential debt, the cancelled amount would still not be considered ordinary income under the general rule and no tax is payable. Regardless of which box is checked, the consumer would not be subject to income tax on acquisition indebtedness [2]. But how box #5 is checked will affect how the taxpayer will treat the cancelled debt.

A Form 1099 is typically furnished by a person or entity to the taxpayer as evidence of potentially reportable income for tax purposes. It is required to be issued for the year in which an “event” occurs that essentially forecloses any options of collecting the debt against the borrower, such as a non-judicial foreclosure sale.

The purpose of box #5 on Form 1099C is to give guidance to the taxpayer (and the IRS) about the potential application of an exception or exclusion that is conditioned upon the taxpayer’s personal liability for the cancelled or forgiven debt. But the form is only evidence and does not definitively characterize the amount in question. When a taxpayer is issued a 1099C he or she is obligated to complete Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness [and Section 1082 Basis Adjustment]), which includes instructions on how to calculate the amount of the cancelled debt subject to the acquisition indebtedness exclusion. Among other things, the taxpayer must determine what portion of the cancelled debt may not be excludable because it was incurred for purposes other than acquiring or improving the principal residence, such as consolidating credit card debt.

In the vast majority of situations a financial institution would not hold a borrower personally liable on residential mortgage debt. Under California law, a creditor may not hold a borrower personally liable for any portion of a debt not satisfied following a disposition of the property under a power of sale clause (i.e., non-judicial foreclosure) [3]. A deficiency against the borrower may be allowed through judicial foreclosure of a residential mortgage loan that is not a “purchase money” loan, but lenders seldom resort to this process [4]. Nevertheless, a lender may have reasons to check “yes” in box #5 where the cancellation of (non-purchase money) debt is associated with a loan modification and the borrower remains on the property. Also, where the lender has agreed to a “short sale” (an approved sale by the borrower in satisfaction of the outstanding debt), the lender may wish to preserve its rights in case the sale was deemed not to be made at arms’ length (though the law in this area may not be settled).

When a financial institution faces questions or complaints from consumers about Form 1099C, it would be helpful to refer them to IRS Publication 4681, which explains in detail how the exclusion works, and Form 982, which the taxpayer must complete in order to account for the cancelled debt properly.

  1. Among the other differences from the 2007 Act, as amended, are that the amount excluded from gross income is capped at $250,000 ($125,000 for married individual filing a separate return) for state tax purposes, and the aggregate amount treated as acquisition indebtedness for any period is capped at $800,000 ($400,000 in the case of a married individual filing a separate return), compared to $2 million and $1 million respectively under the 2007 Act, as amended.
  2. A possible explanation for the confusion is that, in California, a loan that is non-recourse is almost synonymous with a residential real estate loan, and by this rationale, a loan for which the debtor is personally liable may be construed as an unsecured debt that does not qualify for the qualified principal residence indebtedness exclusion. This concern should be mitigated, however, by the lender’s description of the debt in box #4, which would indicate that the cancelled debt relates to a residential mortgage loan.
  3. Code of Civil Procedure Section 580d).
  4. Code of Civil Procedure Section 580(b). This provision does not apply to a refinance of the purchase money loan; therefore, a deficiency judgment through judicial foreclosure is possible.

The information contained in this CBA Regulatory Compliance Bulletin is not intended to constitute, and should not be received as, legal advice. Please consult with your counsel for more detailed information applicable to your institution.

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