Foreclosure issues and rules

Congress recently passed legislation providing foreclosure relief to taxpayers.  Prior to this new legislation a taxpayer was subject to paying income tax on any debt that was forgiven.  The new legislation known as the Morgage Forgiveness Debt Relief Act of 2007 eliminates this additional income in most cases for the years 2007 through 2009.  There is a limit on the relief of $2,000,000 that is secured by a principal residence and is incurred in the acquisition, construction or substantial improvement of the principal residence.  Note the definition above.  Home equity debt will not qualify, refinanced debt to the extent it exceeds the "original acquisition indebtedness" will not qualify.  Taxpayers can obviously have only one principal residence.  One last item, if you qualify for the forgiveness, the amount of the forgiven debt reduces your tax basis in the residence, so effectively the gain on the future sale of the residence will be increased by the amount of the debt that qualifies for relief.  The exclusion also does not apply to taxpayers in Chapter 11 bankruptcy.  The Emergency Economic Stabilization Act has extended this provision through 2012.

California recently passed a law to conform to the federal rules above on foreclosure relief for taxpayers.

Refinancing personal residences

Many people either have refinanced their home or are considering refinancing.  There are some things to keep in mind when you refinance.

If you refinance your current mortgage and increase the amount of your mortgage, in effect you are taking out a home equity loan for the additional amount over and above your current mortgage amount.  The current mortgage amount is generally called "original acquisition indebtedness".  Original acquisition indebtedness can only go down and never up according to the IRS rules and regulations.  Therefore, if you increase your indebtedness, now home equity debt, you could be limiting your future interest deductions.

Interest on original acquisition indebtedness is generally tax deductible (subject to some limitations based on the amount), but interest on home equity debt is only deductible on interest on up to $100,000 of debt.  Interest on home equity debt in excess of $100,000 is personal interest.

If you use the proceeds from refinancing to improve your home, the original acquisition indebtedness increases by the amount of the imrovment costs but this is the only exception.

Also be sure to consider the fact that interest paid on home equity debt that was not used to improve a personal residence is considered an adjustment for the Alternative Minimum Tax (AMT) which more and more taxpayers are finding they are subject.

Selling your home and current tax rules

The current tax rules allow an individual to exclude up to $250,000 of gain on the sale of a personal residence.  The exclusion is $500,000 for a married couple.  The only requirement is that the home must be used as the personal residence for two out the last five years.  If the home is sold before the two year period and there is a gain there may be some relief available if the sale is due to a change in place of employment, health, or unforseen circumstances. A reduced exclusion may be available in these situations.

Records of the cost of your home and subsequent improvements should still be maintained if there is any possibility the gain on the sale may be taxable in the future, if the residence is rented or a home office deduction is claimed on the home. 

If you have placed your residence for rental you will still qualify for the exclusion if you lived in your home for two out of the last five years, however any depreciation claimed after May 6, 1997 is subject to taxation as a gain to the extent of the depreciation claimed.