The Difference Between the Mortgage Forgiveness Debt Relief Act of 2007 and State Anti-Deficiency Laws

A week or so ago, I wrote a post detailing the Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA) because I'd read a number of posts where the authors confused the MFDRA with their state's anti-deficiency laws. That post was lost when AR timed out on me when I went to publish the post.

If you want to get the information from the horse's mouth (the IRS) here's a link to the IRS publication regarding the MFDRA. I'm summarizing it below.

The main difference between MFDRA is who is providing the protection. MFDRA is federal law and applies to your federal income taxes. Anti-deficiency laws vary state by state and protect the borrower from the lender holding them liable for the deficiency (the difference between the amount owed and the actual sale price) in a short sale or foreclosure.

What is the MFDRA 2007

As a response to the mortgage and credit crisis, Congress passed this Act in late December of 2007  It generally, permits a taxpayer to exclude the forgiveness of cancellation of certain debt from counting as ordinary income on their federal taxes if the property at issue is the taxpayer's principal residence. Cancellation or forgiveness of debt usually occurs when the lender modifies the terms of a mortgage, accepts a short sale or forecloses on a property. MFDRA will apply to forgiveness and cancellation of debt occurring in 2007, 2008 or 2009.

Prior to December 2007 Mortgage Debt Relief Was Handled Differently

Prior to the enactment of the MFDRA, when a lender offered to modify the terms of the loan by either forgiving or canceling debt, the taxpayer would have to include the debt relief amount as ordinary income.

For example, if there was $300,000 owed on the taxpayer's principal residence and the property only sold for $250,000, prior to MFDRA, the taxpayer would have to show the debt relief of $50,000 as income on his/her taxes.

With the MFDRA, the taxpayer does not have to include that $50,000 debt relief as income.

Debts to Which the MFDRA Applies

Not all forgiven or canceled debt qualify for MFDRA treatment.  It only applies to forgiven or canceled debt that was used to buy, build or substantially improve the taxpayer's taxpayer's principal residence.

What Happens With REFINANCED HOMES?

Debt used to refinance a taxpayer's home will qualify up to the extent that the principal balance of the old mortgage, immediately prior to refinancing would have qualified.

What About Debt Forgiveness on a second home, credit cards or car loans?

This property DOES NOT QUALIFY for MFDRA treatment. Only canceled debt used to buy, build or improve the taxpayer's principal residence or refinance debt incurred for those purposes qualifies for this exclusion.

Check With Your Tax Advisor Because If Part of the Forgiven Debt Doesn't Qualify for Exclusion from Income, It May Qualify Under A Different Provision

The forgiven debt may qualify under the "insolvency" exclusion. Normally, a taxpayer is not required to include forgiven debts in income to the extent that the taxpayer is insolvent. A taxpayer is insolvent when his or her total liabilities exceed his or her total assets. There are additional exclusions that may be explored with your tax advisor.

 What are Anti-Deficiency Laws

Anti-deficiency laws differ by state and usually protect the borrower from being liable for the difference in the sale price of the principal residence and the amount owed on the principal residence. If a borrower is protected by anti-deficiency laws, it protects them from the lender holding the borrower liable for the deficiency. Many restrict this protection to purchase money loans only, so if the property is refinanced then the borrower may lose the protection of the anti-deficiency laws. I will cover this in more detail in a future post.

 THIS INFORMATION IS PROVIDED FOR EDUCATIONAL AND INFORMATIONAL PURPOSES ONLY. IT IS NOT TAX OR LEGAL ADVICE. INDIVIDUALS ARE STRONGLY ENCOURAGED TO SEEK THE GUIDANCE OF THEIR OWN TAX AND LEGAL ADVISORS FOR ADVICE REGARDING THEIR SPECIFIC FACTS AND CIRCUMSTANCES.

Please remember me and Asset Preservation, Inc. for all of your 1031 exchanges and questions.

 Lisa A. Lambert, Esq. 877.646.1031 or LisaL@apiexchange.com

Asset Preservation, Inc. 800.282.1031 or info@apiexchange.com or www.apiexchange.com