NEW YORK, Oct. 27, 2008, /PRNewswire/ -- In a July 8, 2008 speech on the U.S. housing market, Treasury Secretary Henry M. Paulson, Jr. reported that 1.5 million foreclosures were started in 2007, and some economists estimate that about 2.5 million foreclosures will be started in 2008. By comparison, there were only 800,000 foreclosures in 2004. Those who happen to be among the unlucky ones, are living in a world of hurt and don't need to be facing giant tax bills on top of losing their homes.

"But, before 2007, that was what often happened because any part of their mortgage forgiven after the foreclosure, (such as when the house was sold and the bank forgave the mortgage exceeding the home's sales price), was considered taxable income. Fortunately, a tax law change in the 2007 Mortgage Relief Act saved the day--at least for many foreclosures and debt cancellations during 2007 through 2012," says Robin Christian, Senior Tax Analyst for the Tax & Accounting business of Thomson Reuters.

The help comes in a special provision called the qualified principal residence indebtedness exclusion, according to Christian. To qualify for the qualified prinicipal residence indebtedness tax exclusion,: (1) the cancellation of debt (COD) must occur in a calendar years 2007-2012 and (2) the debt that was canceled must have been incurred to acquire, construct, or improve the individual's principal residence and it must be secured by that residence. Finally, only up to $2 million of COD can be excluded under this provision.

According to Christian, the basis of the taxpayer's residence is reduced (but not below zero) by the amount excluded under this exception. "Thus, the excluded COD will decrease any loss (or increase any gain) on the sale of the residence," she says. "But, this usually doesn't matter as the loss isn't deductible and any gain up to $250,000 ($500,000 in the case of married taxpayers) usually qualifies for the home-gain exclusion, so it isn't taxable anyway." She provides this example:

A couple of years ago, Lois and Clark paid $500,000 for their home. Now, thanks to a down real estate market, their home is now worth $350,000, their mortgage balance is $450,000, and, to top it off, Clark has lost his job. With no way to make the monthly payments and no hope of selling and being able to pay off the mortgage, Lois and Clark hand the deed back to the bank and walk away from their home. The bank sells the house for $350,000 and forgives the $100,000 remaining loan balance. As far as Lois and Clark are concerned, they've done nothing but lose their home and all the money they put into it.

For tax purposes, however, two things have happened--they've sold their home for a $150,000 loss and realized COD income of $100,000--and the two transactions do not offset each other. In fact, the loss from the sale of the residence is never deductible, whereas the COD income is fully taxable, unless an exception applies. Fortunately, for Lois and Clark, they can exclude the $100,000 of COD under the qualified principal residence indebtedness exclusion. "This will decrease the basis in their home by $100,000, so their loss will now be $50,000 instead of $150,000, but who cares--it's not deductible anyway," says Christian.

Bottom line: The foreclosure has no impact on their income taxes. Note, however, that the COD will need to be reported on a special form attached to their 2008 Form 1040--Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness). Basically, you use this form to report the COD, and then indicate that it is excluded under the qualified principal residence indebtedness exclusion and that the residence's basis is reduced by the amount excluded.

"Unfortunately, this special COD exclusion does not apply to all home loans--it doesn't work for second mortgages or home equity loans that were used for purposes other than to improve the taxpayer's principal residence, nor does it work for vacation home mortgages," warns Christian. "It will only help those who borrowed too much to acquire, build, or improve a principal residence."

However, other exclusions may apply. For example, COD that occurs during bankruptcy proceedings is excluded from income as is COD, to the extent of the borrower's insolvency immediately before the debt forgiveness event occurs. Also, there's no COD income if your mortgage was nonrecourse (meaning, you are not liable to the extent the loan balance exceeds your home's value) or seller financed (that is, the home's prior owner loaned you the money to buy the home).

"The COD exclusion for principal residence indebtedness may well save the day if your home was foreclosed on in 2008," says Christian. "Be careful though--real life is never as simple as our examples. Often a foreclosure is a drawn out painful process, occurring in several stages over more than one year --and each case is unique. That's where your tax professional can be instrumental in getting the best results," advises Christian.

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