Hey, IRS, ain't that a kick in the head?

WASHINGTON — For homeowners around the country who are seriously delinquent on their mortgages and hoping for relief, the IRS has bad news: If your lender agrees to modify your loan and forgive any part of your debt, you could owe federal income taxes on the amount forgiven.

Think of it as the tax code's "kick-em-while-they're-down" rule.

When personal debts are canceled by a creditor, the amount forgiven is treated as ordinary income under the Internal Revenue Code unless the taxpayer is insolvent or bankrupt.

Worse yet, the lender is required to report the amount canceled to the IRS.

Ouch! This is especially bad news for the growing numbers of credit-impaired subprime borrowers across the nation who find themselves "upside down" in the current real-estate market.

They owe more on their mortgage than the value of their house, thanks to noxious combinations of zero down payments, declining property values and hefty payment increases they can't afford.

Diane Thompson, an attorney with the Land of Lincoln Legal Assistance Foundation in East St. Louis, Mo., tells of one client who learned about the Catch-22 the hard way.

After the homeowner negotiated a loan-modification agreement with her lender, she assumed she was done with the matter.

But a year later, the IRS demanded a large tax payment on the amount the lender forgave — a tax bill equal to her annual income.

Never got any money

Her lender had dutifully submitted a Form 1099-C to the IRS, alerting the agency to the woman's extra "income" from the loan modification.

The homeowner never had received that income in any tangible way; she couldn't deposit it in her bank account.

But under federal law, the IRS had every right to come after her for unpaid taxes.

Similar situations are likely to pop up around the nation in the coming year as lenders bend over backward to modify thousands of troubled loans before they go to foreclosure.

Proposed bipartisan legislation on Capitol Hill could soften some of the impact on financially stressed homeowners, however.

The Mortgage Cancellation Tax Relief Act of 2007 (HR 1876) would amend the tax code to exclude debt forgiveness on principal home mortgages from treatment as income.

Introduced in mid-April by U.S. Reps. Robert Andrews, D-N.J., and Ron Lewis, R-Ky., the bill would allow lenders to restructure delinquent mortgages without worrying about income-tax hand grenades hitting their borrowers the following year.

The legislation potentially could assist many other homeowners in financial trouble who negotiate pre-foreclosure "short sales," deeds-in-lieu-of-foreclosure or whose foreclosure proceeds are insufficient to pay off their mortgage debt.

A foreclosure alternative

Short sales are increasingly commonplace.

Say you are seriously behind on your payments and a loan modification or rate reduction won't solve the problem because you've just lost your job.

As an alternative to foreclosure, your lender might suggest a quick sale of the house, often to an investor who'll buy it as-is at a discounted price.

If the short sale proceeds are $10,000 less than the outstanding mortgage balance, and your lender agrees to forgive that amount, the Andrews-Lewis bill would allow you to obtain that relief tax-free.

Under current law, by contrast, your lender would be required to report the $10,000 in phantom income to the IRS.

Ditto if you went to foreclosure and the sale proceeds yielded $10,000 — or $50,000 — less than the outstanding debt owed to the lender.

Proponents of the debt-relief reform bill argue that short sales, mortgage delinquencies and foreclosures are painful situations for most homeowners, and there's no public-policy purpose served by smacking them with tax penalties that make things even worse.

In the case of below-market short sales, most homeowners have already suffered sizable capital losses that are not tax-deductible.

They've lost thousands of dollars in equity.

Why pile on?

Good chance of passing

The outlook for the bill: It's before the House Ways and Means Committee, Congress' primary tax legislative body.

Most of the majority Democratic leaders on the housing and banking committees have called upon banks and mortgage companies to work out solutions to keep troubled homeowners out of foreclosure.

So a bipartisan tax-fairness bill like this one should have a reasonable chance of passage.

Kenneth R. Harney: kenharney@earthlink.net