With the Obama administration and private lenders considering mortgage principal-reduction programs to help financially distressed homeowners, the Internal Revenue Service has issued a new advisory for taxpayers who receive such assistance.
The IRS gets involved in mortgage principal write-downs because the federal tax code generally treats any forgiveness of debt in excess of $600 as ordinary taxable income to the recipient.
However, under legislation that took effect in 2007, certain home mortgage debt cancellations – such as through loan modifications, short sales or foreclosures – can be exempted.
Sheila C. Bair, chairwoman of the Federal Deposit Insurance Corp., said her agency is working on a new program to expand the use of principal mortgage reductions to keep underwater borrowers out of foreclosure. Major banks and mortgage companies have preferred monthly payment reductions and other loan modifications over cuts of principal balances, but some have made limited use of the concept.
One of the largest servicers of subprime home loans, Ocwen Financial Services of West Palm Beach, Fla., has strongly advocated principal reductions to keep people out of foreclosure, and it has claimed broad success with them. Ron Faris, president of Ocwen, told a congressional subcommittee this month that, compared with borrowers who receive partial forgiveness on the principal, those with negative equity can be twice as likely to re-default after a standard payment-reduction loan modification.
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