Debt Forgiveness: Watch Out for the Tax Consequences

On Dec. 20, 2007, the Mortgage Debt Relief Act of 2007 (hereinafter referred to as “the Act”) was enacted. The Act provides financially strapped homeowners with some relief in connection with treating debt forgiveness as income. Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on a principal residence that occurred in 2007, 2008 or 2009. Moreover, there is no dollar limit if the principal balance of the loan was less than $2 million ($1 million if married filing separately for the tax year) at the time the loan was forgiven.

Under the Act

What the Act does not do is provide relief to all forgiven or cancelled debt. Its application is severely limited to a forgiven or cancelled debt used to buy, build or substantially improve a principal residence or to refinance debt used for those purposes.

• There is no relief for any debt forgiveness for a vacation or investment home.
• There is no relief for credit card debt reduction.
• There is also no relief available for cash-out mortgages whether the cash take-out takes the form of a refinanced first mortgage, a second mortgage, a home equity line of credit or similar arrangement. (Exception: if the cash-out was specifically used to improve the home and the homeowner has adequate records to prove it.)

For example, if an individual takes out a home equity line in the amount of $50,000 to pay off credit card debt, then sells his home, via a short sale, for $300,000 but owes $350,000 on the first mortgage and $50,000 on the equity line used to pay credit card debt, the borrower will be required to claim the $50,000 as income on his federal income tax return. Moreover, the borrower will most likely be required to claim the entire debt forgiven, $100,000, on his state income tax return because the Mortgage Debt Relief Act only applies to federal income tax.

This is significant because many of us have or will have clients whose principal residence is encumbered by a cash-out mortgage or is on the brink of foreclosure, or the client is compelled to sell the home by way of a short sale. Some of us may have clients whose vacation homes and/or investment properties are in foreclosure or are short sales. If that is the case, either a portion or all of the debt forgiveness will be considered taxable income. The client will receive a 1099C from the lender and the client will have to claim the debt forgiveness on his or her federal and state income tax return. If your client is not yet divorced, a joint federal and state income tax return can be filed, and an agreement can be reached as to how the tax debt associated with the marital property will be apportioned.

However, suppose your client is already divorced and foreclosure or a short sale of marital property was not contemplated in the property settlement agreement. How are you going to deal with the tax consequences of the debt forgiveness? The party who received the 1099 and is compelled to claim the debt forgiveness on his or her federal and state income tax return will want the ex-spouse to share in the tax consequences. Most likely, the party who did not receive the 1099 will refuse to share in the tax debt, especially if the divorce was hotly contested. Thus, it is imperative that debt forgiveness associated with a client's principal residence, vacation home, investment property, credit card debt reduction etc. be addressed in your client's property settlement agreement. Even if the parties are solvent when the property settlement agreement is drafted, in today's economy, it is not a far-fetched scenario that an individual could lose his/her job, be unemployed for a significant period of time, and have his/her home or homes sit on the market for a year or more with no offers in sight. That is a recipe for foreclosure or a short sale. By simply including a clause in a property settlement that addresses how the tax consequences will be treated in the event of a short sale or debt forgiveness, you will alleviate a litany of post judgment applications, as well as a potential malpractice action.

Sample Clause

The following is a sample clause to include in a property settlement agreement that contemplates a short sale or foreclosure:

As stated in Paragraph ___, the former marital home, located at ______________________, is currently listed for sale in the amount of $________. The current balance on the mortgage is $_______. The current balance on the equity line is $_______. The equity line was used to pay off credit card debt in the amount of $________. The parties have agreed in Paragraph ___ that the net proceeds from the sale of the former marital home shall be shared equally. However, in the event the former marital home is sold by way of a short sale or is foreclosed upon, the Mortgage Debt Relief Act of 2007 will not apply. Therefore, any and all debt forgiven is taxable and required to be included as income on the parties' federal and state income tax returns. As of the date of this Agreement, the former marital home is not yet sold. Since there is no way of determining when or how much the former marital home will sell for, the parties shall share equally in any and all debt forgiveness associated with the former marital home. If the parties are divorced when the 1099C is to be included as income on the federal and state income tax return, each party shall claim one-half of the income set forth in the 1099C on their individual federal and state income tax returns. If the parties are married when the 1099C is to be included as income on the federal and state income tax returns, the parties shall file jointly, claiming the debt forgiveness as income and shall share equally in any and all federal and state taxes due and owing.

Conclusion

The clause set forth above is a general clause. It is important to tailor any provision included in a property settlement agreement to the facts of your case. For instance, if one party willfully allows the former marital home to go into foreclosure, then language should be included that holds the responsible party solely accountable for the debt forgiveness.

Laurence J. Cutler, a member of this newsletter's Board of Editors, is the founding partner in Cutler, Townsend, Tomaio & Newmark, LLC, Morristown, NJ. Erin D. DeGeorge is a senior associate in the firm.

In light of the current economic crises plaguing our country, many of us may have clients whose homes are on the brink of foreclosure, or are being sold by way of a short sale. The client may also have staggering credit card debt. Therefore, when drafting a property settlement agreement that involves debt forgiveness (i.e., foreclosure, short sale, reduction in credit card debt), it is critical that matrimonial attorneys be aware of the tax consequences because the financial impact on a client can be enormous.

Background

Historically, if debt were forgiven or cancelled by a commercial lender, it had to be included as income on one's federal and state tax return, and was taxable. For example, if the total amount of the mortgage debt immediately prior to foreclosure was $220,000, and the fair market value of the property was $200,000, the amount of the debt forgiven, $20,000, was treated as taxable income ' unless of course the borrower qualified for an exception under the Federal Tax Code, i.e., bankruptcy, insolvency, certain farm debt, and non-recourse loans.

On Dec. 20, 2007, the Mortgage Debt Relief Act of 2007 (hereinafter referred to as “the Act”) was enacted. The Act provides financially strapped homeowners with some relief in connection with treating debt forgiveness as income. Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on a principal residence that occurred in 2007, 2008 or 2009. Moreover, there is no dollar limit if the principal balance of the loan was less than $2 million ($1 million if married filing separately for the tax year) at the time the loan was forgiven.

Under the Act

What the Act does not do is provide relief to all forgiven or cancelled debt. Its application is severely limited to a forgiven or cancelled debt used to buy, build or substantially improve a principal residence or to refinance debt used for those purposes.

• There is no relief for any debt forgiveness for a vacation or investment home.
• There is no relief for credit card debt reduction.
• There is also no relief available for cash-out mortgages whether the cash take-out takes the form of a refinanced first mortgage, a second mortgage, a home equity line of credit or similar arrangement. (Exception: if the cash-out was specifically used to improve the home and the homeowner has adequate records to prove it.)

For example, if an individual takes out a home equity line in the amount of $50,000 to pay off credit card debt, then sells his home, via a short sale, for $300,000 but owes $350,000 on the first mortgage and $50,000 on the equity line used to pay credit card debt, the borrower will be required to claim the $50,000 as income on his federal income tax return. Moreover, the borrower will most likely be required to claim the entire debt forgiven, $100,000, on his state income tax return because the Mortgage Debt Relief Act only applies to federal income tax.

This is significant because many of us have or will have clients whose principal residence is encumbered by a cash-out mortgage or is on the brink of foreclosure, or the client is compelled to sell the home by way of a short sale. Some of us may have clients whose vacation homes and/or investment properties are in foreclosure or are short sales. If that is the case, either a portion or all of the debt forgiveness will be considered taxable income. The client will receive a 1099C from the lender and the client will have to claim the debt forgiveness on his or her federal and state income tax return. If your client is not yet divorced, a joint federal and state income tax return can be filed, and an agreement can be reached as to how the tax debt associated with the marital property will be apportioned.

However, suppose your client is already divorced and foreclosure or a short sale of marital property was not contemplated in the property settlement agreement. How are you going to deal with the tax consequences of the debt forgiveness? The party who received the 1099 and is compelled to claim the debt forgiveness on his or her federal and state income tax return will want the ex-spouse to share in the tax consequences. Most likely, the party who did not receive the 1099 will refuse to share in the tax debt, especially if the divorce was hotly contested. Thus, it is imperative that debt forgiveness associated with a client's principal residence, vacation home, investment property, credit card debt reduction etc. be addressed in your client's property settlement agreement. Even if the parties are solvent when the property settlement agreement is drafted, in today's economy, it is not a far-fetched scenario that an individual could lose his/her job, be unemployed for a significant period of time, and have his/her home or homes sit on the market for a year or more with no offers in sight. That is a recipe for foreclosure or a short sale. By simply including a clause in a property settlement that addresses how the tax consequences will be treated in the event of a short sale or debt forgiveness, you will alleviate a litany of post judgment applications, as well as a potential malpractice action.

Sample Clause

The following is a sample clause to include in a property settlement agreement that contemplates a short sale or foreclosure:

As stated in Paragraph ___, the former marital home, located at ______________________, is currently listed for sale in the amount of $________. The current balance on the mortgage is $_______. The current balance on the equity line is $_______. The equity line was used to pay off credit card debt in the amount of $________. The parties have agreed in Paragraph ___ that the net proceeds from the sale of the former marital home shall be shared equally. However, in the event the former marital home is sold by way of a short sale or is foreclosed upon, the Mortgage Debt Relief Act of 2007 will not apply. Therefore, any and all debt forgiven is taxable and required to be included as income on the parties' federal and state income tax returns. As of the date of this Agreement, the former marital home is not yet sold. Since there is no way of determining when or how much the former marital home will sell for, the parties shall share equally in any and all debt forgiveness associated with the former marital home. If the parties are divorced when the 1099C is to be included as income on the federal and state income tax return, each party shall claim one-half of the income set forth in the 1099C on their individual federal and state income tax returns. If the parties are married when the 1099C is to be included as income on the federal and state income tax returns, the parties shall file jointly, claiming the debt forgiveness as income and shall share equally in any and all federal and state taxes due and owing.

Conclusion

The clause set forth above is a general clause. It is important to tailor any provision included in a property settlement agreement to the facts of your case. For instance, if one party willfully allows the former marital home to go into foreclosure, then language should be included that holds the responsible party solely accountable for the debt forgiveness.

Laurence J. Cutler, a member of this newsletter's Board of Editors, is the founding partner in Cutler, Townsend, Tomaio & Newmark, LLC, Morristown, NJ. Erin D. DeGeorge is a senior associate in the firm.