Analysis of the Proposed Tax Exclusion for Canceled Mortgage Debt Income
Analysis of the Tax Exclusion for Canceled
Mortgage Debt Income
Updated October 8, 2008
Mark P. Keightley
Analyst in Public Finance
Government Finance Division
American Law Division
Analysis of the Tax Exclusion for
Canceled Mortgage Debt Income
During 2008, the rate of foreclosures and mortgage defaults has been rising to
new levels. As lenders and borrowers work to resolve indebtedness issues, some
transactions are resulting in cancellation of debt. Mortgage debt cancellation can
occur when lenders restructure loans, reducing principal balances, or sell properties,
either in advance, or as a result, of foreclosure proceedings. Historically, if a lender
forgives or cancels such debt, tax law has treated it as cancellation of debt (COD)
income subject to tax. Exceptions have been available for taxpayers who are
insolvent or in bankruptcy, among others — these taxpayers may exclude canceled
mortgage debt income under existing law.
The Mortgage Forgiveness Debt Relief Act of 2007, P.L. 110-142, signed into
law on December 20, 2007, temporarily excludes qualified COD income. Thus, the
act allows taxpayers who do not qualify for the existing exceptions to exclude COD
income. The provision is effective for debt discharged before January 1, 2010. The
Emergency Economic Stabilization Act of 2008, P.L. 110-343, extends the exclusion
of COD income to debt discharged before January 1, 2013.
A rationale for excluding canceled mortgage debt income has focused on
minimizing hardship for households in distress. Policymakers have expressed
concern that households experiencing hardship and that are in danger of losing their
home, presumably as a result of financial distress, should not incur an additional
hardship by being taxed on canceled debt income.
Some analysts have also drawn a connection between minimizing hardship for
individuals and consumer spending; reductions in consumer spending, if significant,
can lead to recession. Additionally, legislators have been pursuing Federal Housing
Authority (FHA) and government-sponsored enterprise (GSE) reform efforts, in part
to alleviate the current mortgage crisis. The most recent changes were enacted by the
Housing and Economic Recovery Act of 2008, P.L. 110-289.
As efforts to minimize the rate of foreclosure are being made, lenders are, in
some cases, renegotiating loans with borrowers to keep them in the home. For some
policymakers, the exclusion of canceled mortgage debt income may be a necessary
step to ensure that homeowner retention efforts are not thwarted by tax policy.
Opponents of an exclusion for canceled mortgage debt income might argue that
the provision would make debt forgiveness more attractive for homeowners, and
could encourage homeowners to be less responsible about fulfilling debt obligations.
This report will be updated in the event of significant legislative changes.
Cancellation of Indebtedness Income..............................2
Gain From the Disposition of Property.............................3
Selected Legislation in the 109th Congress..........................4th
Selected Proposals Made Prior to the 109 Congress..................5
Homeownership Retention or Loss................................6
Equity Among Homeowners.....................................7
What Kind of Exclusion?........................................9
What Types of Canceled Debt?..................................10
Which Homeowners Should Be Eligible?..........................11
Should Basis Be Adjusted?.....................................12
List of Tables
Table 1. Tax Treatment of Canceled Debt Income Assuming
No Exclusions Apply...........................................6
Table 2. Reported Canceled Debt.....................................9
Analysis of the Tax Exclusion for Canceled
Mortgage Debt Income
Mortgage debt cancellation occurs when lenders engage in loss-mitigation
solutions that either (1) restructure the loan and reduce the principal balance or (2)
sell the property, either in advance, or as a result of foreclosure proceedings.1 Under
current law, the canceled debt (sometimes referred to as discharge of indebtedness)
may be income subject to taxation.
Recently enacted law allows canceled mortgage debt income to be excluded
from taxation. The rationales for this change are to minimize hardship for households
in distress and to ensure that non-tax-related homeowner retention efforts are not
thwarted by tax policy. Critics argue that the exclusion could encourage homeowners
to be less responsible about fulfilling debt obligations.2 Critics may also argue that
owner-occupied housing is sufficiently subsidized even without a COD income
This report begins with an overview and analysis of the historical tax treatment
of canceled debt income. Next, the changes enacted by P.L. 110-142 and P.L. 110-
For federal income tax purposes, there are two types of income that may arise
when an individual’s mortgage is fully or partially canceled: cancellation of
indebtedness income and gain from the disposition of property.
1 In order to avoid foreclosure proceedings, lenders and homeowners may agree to “short
sell” properties or “deed-in-lieu” transactions. In short sales, the property is listed for sale
with the lender agreeing to take a reduced payoff on the outstanding loan amount. If the
property cannot easily be sold, the homeowner may give the lender the deed to the property
in lieu of foreclosure proceedings. The benefit of either option is that the homeowner does
not suffer the adverse credit impacts and possible stigma of foreclosure and the lender can
clear a non-performing loan without the associated costs of foreclosure, eviction, and
2 Martin Vaughn, “Taxes - Panel Poised To Approve Forgiven Mortgage Debt Bill,”
CongressDaily, September 26, 2007.
Cancellation of Indebtedness Income
When all or part of a taxpayer’s debt is forgiven, the amount of the canceled
debt is ordinarily included in the taxpayer’s gross income.3 This income is typically
referred to as cancellation of debt (COD) income. The borrower will realize ordinary
income to the extent the canceled debt exceeds the value of any cash or property
given to the lender in exchange for cancelling the debt. Lenders report canceled debt
to the Internal Revenue Service (IRS) using Form 1099-C, and borrowers must
generally include the amount in gross income in the year of discharge.
Exceptions. Historically, there have been several exceptions to the general
rule that canceled debt is included in the gross income of the borrower. Section 108
of the Internal Revenue Code (IRC) contains two exceptions that are particularly
relevant in the case of canceled home mortgage debt: a borrower may exclude
canceled debt from gross income if (1) the debt is discharged in Title 11 bankruptcy
or (2) the borrower is insolvent (that is, has liabilities that exceed the fair market
value of his or her assets, determined immediately prior to discharge).4
In the case of the bankruptcy exception, the debt must be discharged by the court5
overseeing the bankruptcy proceedings or pursuant to a plan approved by that court.
No involvement by a court is necessary for a taxpayer to claim an insolvency
exception — the taxpayer calculates his or her assets and liabilities to determine
whether he or she is insolvent. For an insolvent taxpayer, the amount of COD income6
that may be excluded is limited to the amount by which the taxpayer is insolvent.
For both the bankruptcy and insolvency exceptions, a taxpayer who excludes
canceled debt must essentially give back some of the benefit of the exclusion.
Specifically, the taxpayer must reduce certain beneficial tax attributes, including
basis in property, that would otherwise decrease the taxpayer’s income or tax liability7
in future years. The attributes are reduced until the reductions generally account for
the excluded amount. As a result of the attribute reduction, the taxpayer may be
subject to tax on the excluded COD income in years following the year of discharge
— in other words, the tax on the COD income is deferred.
In addition to the IRC § 108 exclusions, there are several other circumstances
under which COD income may be excluded. For example, a taxpayer with
3 See IRC § 61(a)(12); see also, U.S. v. Kirby Lumber Co., 284 U.S. 1 (1931)(holding, prior
to the IRC explicitly addressing the treatment of COD income, that a taxpayer had realized
income from the discharge of a debt).
4 See IRC § 108(a)(1)(A) and (B).
5 See IRC § 108(d)(2).
6 See IRC § 108(a)(3).
7 See IRC § 108(b). The taxpayer reduces basis in property in the order set out by Treasury
Regulation § 1.1017-1. Basis reduction occurs in the taxable year following the debt
discharge. See IRC § 1017(a).
nonrecourse, as opposed to recourse, debt8 will not realize COD income.9 Other
examples of when COD income may be excluded from the borrower’s income are if
the cancellation was intended to be a gift10 or was the result of a disputed debt.11
Gain From the Disposition of Property
When an individual sells property, the excess of the sales price over the original
cost plus improvements (adjusted basis) is normally gain subject to tax.12 If the
property was held for more than 12 months, the gain is taxed at a maximum rate of
15% rather than regular income tax rates. If the property was held for less than 12
months, the gain is taxed at regular income tax rates.
In situations involving canceled home mortgage debt, if the lender takes the
home in exchange for the debt cancellation, the homeowner realizes gain from the
disposition of property in the amount that the property’s fair market value (or the
amount of outstanding debt, in the case of nonrecourse debt) exceeds the taxpayer’s
adjusted basis in the property.13 A taxpayer may have both gain from the disposition
of property and COD income.
IRC § 121 provides an exclusion for gain from the sale or disposition of a
personal residence. The provision excludes gain of up to $250,000 for single
taxpayers and $500,000 for married couples filing joint returns if the taxpayer meets
a use test (has used the house as the principal residence for at least two of the last five
years) and an ownership test (has owned the house for at least two of the last five
years). A taxpayer who does not meet the qualifications may be eligible for a partial
exclusion if the home was sold because of a change in employment or health or due
to unforeseen circumstances.14 Additionally, other taxpayers may qualify for special
treatment (e.g., members of the armed forces).15 The exclusion can generally be used
every two years.
8 Recourse debt is debt for which the borrower is personally liable if he or she defaults on
the loan. Nonrecourse debt is secured by property, and the borrower is not personally liable
for the debt; if he or she defaults on the loan, the lender’s only remedy is to seize the
9 For more information, see U.S. Department of the Treasury, Internal Revenue Service,
Questions and Answers on Home Foreclosure and Debt Cancellation, available at
[ h t t p : / / www.i r s.go v/ newsr oom/ a r t i c l e / 0,,i d=174034,00.ht ml ] .
10 See IRC § 102.
11 See Zarin v. Comm’r, 916 F.2d 110, 115 (3rd Cir. 1990).
12 See IRC §§ 61(a)(3) and 1001.
13 For more information, see U.S. Department of the Treasury, Internal Revenue Service,
Questions and Answers on Home Foreclosure and Debt Cancellation, available at
[ h t t p : / / www.i r s.go v/ newsr oom/ a r t i c l e / 0,,i d=174034,00.ht ml ] .
14 See IRC § 121(c).
15 See IRC § 121(d)(9).
On December 20, 2007,The Mortgage Forgiveness Debt Relief Act of 2007,
P.L. 110-149, was signed into law. The act, among other things, excludes discharged
qualified residential debt from gross income. Qualified indebtedness is defined as
debt, limited to $2 million ($1 million if married filing separately), incurred in
acquiring, constructing, or substantially improving the taxpayer’s principal residence
that is secured by such residence. It also includes refinancing of this debt, to the
extent that the refinancing does not exceed the amount of refinanced indebtedness.
The taxpayer is required to reduce the basis in the principal residence by the amount
of the excluded income. The provision does not apply if the discharge was on account
of services performed for the lender or any other factor not directly related to a
decline in the residence’s value or to the taxpayer’s financial condition. The
provision applies to debt discharges that are made on or after January 1, 2007, and
before January 1, 2010. The provision has been estimated to cost $1.34 billion in16
reduced tax revenue from FY2008 through FY2017.
On October 3, 2008, the Emergency Economic Stabilization Act of 2008, P.L.
extension has been estimated to cost $362 million from FY2009 through FY2018.
Selected Legislation in the 109th Congress
Debt cancellation relief was enacted by the Katrina Emergency Tax Relief Act
of 2005 (KETRA; P.L. 109-73), which became law in September 2005. That
legislation contained temporary tax relief provisions intended to directly and
indirectly assist individuals in recovering from the devastation of Hurricane
Katrina.18 Included in KETRA was a temporary exclusion for non-business debt that
was forgiven by a governmental agency or certain financial institutions. If the
discharge occurred between August 24, 2005, and January 1, 2007, eligible
individuals (e.g., those with their principal place of abode on August 25, 2005, in the
core disaster area) were able to exclude the COD income.
P.L. 110-343 extended the exclusion of COD income contained in KETRA to
individuals located in the Midwestern disaster area. To be eligible for the exclusion,
the discharge of debt must occur before January 1, 2010.
16 U.S. Congress, Joint Committee on Taxation, Estimated Revenue Effects of H.R. 3648,
JCX-98-07, October 5, 2007.
17 U.S. Congress, Joint Committee on Taxation, Estimated Budget Effects of the Tax
Provisions Contained in an Amendment in the Nature of a Substitute to H.R.. 1424 , JCX-
18 For more information, see CRS Report RS22269, Katrina Emergency Tax Relief Act of
Selected Proposals Made Prior to the 109th Congress
A provision enacted in the Tax Reform Act of 1986 (P.L. 99-514, § 405) allows
farmers who are solvent to treat certain COD income as if the farmer were insolvent.
Essentially, discharged, qualified farm debt is excluded from taxation if canceled by
a qualified person. This debt relief is not exclusively mortgage related but has to have
been incurred directly from the operation of a farming business.
In the past, Congress has provided tax relief when mortgage debt is forgiven.
In August 1993, the Omnibus Budget Reconciliation Act (P.L. 103-66, § 13150)
enacted a provision for permanent tax relief to owners of commercial real estate
when some portion of the debt on commercial and investment property was forgiven.
At that time, the conference committee stated the following:
The committee understands that real property has declined in value in some areas
of the nation, in some cases to such a degree that the property can no longer
support the debt with which it is encumbered. The committee believes that where
an individual has discharge of indebtedness that results from a decline in value
of business real property securing that indebtedness, it is appropriate to provide
for deferral, rather than current inclusion, of the resulting income. Generally, that
deferral should not extend beyond the period that the taxpayer owns the19
In 1999 and 2000, the House and Senate, respectively, each passed a tax bill
(H.R. 3081 in the 106th Congress) that provided tax relief for mortgage cancellation,
but neither bill was enacted. During that time period, several regional markets had
experienced severe housing slumps and falling property values. In subsequent yearsth
that legislation was reintroduced (H.R. 666 in the 108 Congress; H.R. 3458 in the
In order to evaluate the policy of including discharged debt as income, it is
helpful to understand how it works. According to economic theory, one way of
defining income is as the change (over the period in question) in a person’s net worth
— that is, the change in the value of the person’s assets minus the change in their
liabilities. By this definition, a forgiven loan is income: a canceled debt reduces a
taxpayer’s liabilities, and thus increases net worth. In the past, tax law has generally
adhered to this concept by providing that if the obligation to repay the lender is
forgiven, the amount of loan proceeds that is forgiven is reportable income subject
19 U.S. Congress, House Committee on the Budget, Omnibus Budget Reconciliation Act of
20 This tax treatment applies to many different kinds of debt, such as auto loans and credit
cards, in addition to mortgage debt. As mentioned previously, if taxpayers are insolvent or
bankrupt, they are fully or partially exempt from taxation on the canceled debt.
This portion of the report provides analysis of the issues associated with the tax
treatment of canceled mortgage debt income.
Homeownership Retention or Loss
In some instances, lenders may restructure or rearrange debt, cancel some debt,
and allow the homeowner to retain ownership of the home. Then, all other things
being equal, the borrower’s net worth has increased as liabilities have declined and
assets have remained unchanged. Alternatively, homeowners may experience debt
cancellation while losing their home, through foreclosure or as a result of voluntarily
deeding the property back to the lender. The homeowner no longer has the asset and,
to the extent the asset value exceeded liabilities, may be worse off as a result of
declining net worth. Additionally, he or she may realize gains or losses, which may
make the taxpayer better or worse off as well.
If the taxpayer is not able to exclude the COD income, then the tax
consequences of the COD income, assuming equal amounts of canceled debt, are the
same regardless of whether the home is retained or lost.
An illustration is shown in Table 1. Assuming residential debt of $200,000, a
loan restructuring could occur, after which the homeowner owes $180,000 and the
lender has agreed to cancel the remaining amount. The discharged debt, $20,000, is
income subject to tax if no exclusion applies (e.g., the taxpayer is not insolvent) —
if a rate of 28% is assumed, the tax liability is $5,600. Alternatively, the home could
have been sold as a result of foreclosure with a sales price of $180,000 along with a
lender agreement to cancel the remaining debt. The $20,000 discharge is income
and, assuming no exclusion applies and the same tax rate, generates the same tax
liability. This is in addition to any taxes the taxpayer may owe on the gain from the
sale of the house.
Table 1. Tax Treatment of Canceled Debt Income
Assuming No Exclusions Apply
Qualified residential debt$200,000
Loan is renegotiated or property disposed of($180,000)
Remaining balance of debt, which is forgiven $20,000
Tax liability (assume 28% rate)$5,600
on canceled debt of $20,000
On the other hand, if the taxpayer is able to exclude the COD income, as is
temporarily allowed in certain circumstances, then the $20,000 discharge is not
included in gross income and the taxpayer does not owe the $5,600 tax liability. As
previously mentioned, current law stipulates that the excluded COD income be
accounted for through reducing the basis in the residence.
The impact of such basis adjustment could differ, depending on whether the
home is retained or lost, in the event that the taxpayer owes taxes when the house is
disposed. A taxpayer who retains the house and sells it in a later year, while
accounting for the excluded COD income through basis adjustment, is able to defer
taxes owed on the disposition until the year of sale.
In contrast, the tax consequences would depend on the timing of the basis
adjustment for a taxpayer that loses a home. If basis was required to be reduced in
the year following discharge, as under IRC § 1017, then the excluded COD income
could not be accounted for because the taxpayer had already disposed of the home.
If basis was required to be reduced earlier (e.g., at the time of discharge), then the
excluded COD income would be accounted for through basis adjustment and the
taxpayer would be worse off than a similarly situated taxpayer who had retained the
house and was able to defer taxes until the year of sale.21
Equity Among Homeowners
An exclusion of income can result in individuals with identical incomes paying
different amounts of tax. A standard of fairness frequently invoked by public finance
analysts in evaluating tax policy is “horizontal equity” — a standard that is met when
persons with identical incomes pay the same amount of tax. Like other exclusions,
an exclusion for debt forgiveness violates the standard of horizontal equity.
Specifically, a person who has no forgiven debt might pay more taxes than a person
who has the same amount of income, a part of which constitutes canceled debt.
An exclusion of income can also reduce the tax system’s progressivity — in
other words, likely favor upper-income individuals. This is likely to occur because
an exclusion of a given amount is more valuable to persons with higher marginal tax
rates. This effect is magnified if homeownership is more concentrated among upper
At this point, an example may be useful for illustrating the effect income tax
exclusions can potentially have on the tax system’s progressivity. Consider two
individual homeowners, both of whom incur $20,000 in COD income. The tax
benefit to the two differs if they are in different tax brackets.22 The value of the
exclusion for a homeowner with lower income, who may be in the 15% income tax
bracket, is $3,000, while the value to another homeowner, with higher income in the
28% bracket, is $5,600. Thus, the higher income taxpayer, with presumably greater
ability to pay taxes, receives a greater tax benefit than the lower income taxpayer.
Over the past quarter century, Congress has enacted tax relief for canceled debt
in several instances, including assisting Hurricane Katrina victims in 2005 and
commercial property owners and farmers during economic downturns in 1986 and
21 The time value of money asserts that the present value of a certain amount of money is
greater than the future value of that same amount. Thus, the cost of a tax payment of $5,600
today is more than the same amount paid in the future.
22 COD income may cause a taxpayer to move to a higher tax bracket.
It could be argued that the market conditions that led to the 1986 and 1993
congressional enactments also exist today. Specifically, property values may be
declining such that the property no longer supports the debt with which it is
encumbered. Currently, the policy issue is posed by residential housing; in 1986, the
problem was the business property of farmers; and in 1993, the issue was business
real property. In providing the 1993 exclusion, Congress acknowledged it was
essentially allowing the taxpayer to defer the income subject to tax because an
adjustment to basis was required.23
The 1986 exclusion of COD income for farmers may provide the most relevant
reference for analysis of the current issues. At the enactment of the exclusion,
Congress was concerned that pending legislation providing Federal guarantees
for lenders participating in farm-loan write-downs would cause some farmers to
recognize large amounts of income when farm loans were canceled. As a result,
these farmers might be forced to sell their farmland to pay the taxes on the24
canceled debt. This tax provision was adopted to mitigate that problem.
Consistent with the 1986 enactment, one rationale expressed in 2008, during the
consideration of the current proposed exclusion of canceled residential debt income,
was the prevention of unintended adverse consequences resulting from foreclosure
prevention efforts. Specifically, as lenders are being encouraged to write-down, or
work out, loans with distressed borrowers, these efforts could be diminished by the
income taxation of canceled debt.
Lenders report canceled debt income on IRS Form 1099-C. The data reported
include all types of debt, not just residential. As shown in Table 2, the number of
Forms 1099-C filed rose by 112% from 2003 through 2007. The amount of canceled
debt also increased from 2003 to 2004, although data for subsequent years are not
available. While specific conclusions about mortgage debt cancellation cannot be
drawn from these data, to the extent that debt cancellation represents financial
distress, the data suggest that the number of financially distressed taxpayers might
be increasing. Alternatively, the rise in debt cancellations may be associated with
increases in the number of debt transactions. In this case, the number of debt
cancellations as a portion of debt may be proportionally the same.
23 U.S. Congress, House Committee on the Budget, Omnibus Budget Reconciliation Act of
24 U.S. Senate Committee on the Budget, Tax Expenditures: Compendium of Background
Material on Individual Provisions, S. Prt. 109-072, 109th Cong., 2nd sess., p. 220.
Table 2. Reported Canceled Debt
Tax YearNumber of FormsAmount of Debt Claimed($1,000)
2003 968,991 $6,229,584
2004 1,048,284 $7,144,087
Source: U.S. Department of the Treasury, Internal Revenue Service, Statistics of Income Division,
reported on Sept. 17, 2007. The 2005, 2006, and 2007 data are projections.
The changes enacted by P.L. 110-149 and then extended by P.L. 110-343 are
temporary and set to expire on January 1, 2013. Congress may choose to let the
changes expire, thus returning the treatment of canceled mortgage debt income to its
original status. Canceled debt income would then be subject to taxation unless the
taxpayer meets a qualified exception (e.g., the taxpayer is insolvent).
If the exclusion on canceled debt income is allowed to expire, improving
awareness about the existing exclusions that apply when there is canceled debt, such
as for insolvency or bankruptcy, may be an option to pursue. Also, it may be
important to ensure that taxpayers know what to do if lenders misreport information
on the Form 1099-C, which could make it appear that the taxpayer has canceled debt
income that has not actually occurred.
Congress may choose to extend the exclusion of canceled debt income.
Additionally, modifications to the exclusion could be made. There are a number of
choices with respect to possible modifications. Which modifications, if any, are
enacted will depend on the goal of policy makers.
What Kind of Exclusion?
One consideration for Congress is whether an exclusion provision should be
temporary or permanent. Early versions of H.R. 3648 (the bill that later became P.L.
110-142) proposed a permanent exclusion, whereas the Administration had suggested
the provision should be temporary.25
Some argue that current housing market conditions, where there are a large
number of homeowners that are “upside down” (the debt owed on the property
exceeds the value of the property), warrant a temporary solution for a crisis that is not
expected to last. A temporary exclusion of canceled debt income would appear to be
25 H.R. 3506 and H.R. 1876/S. 1394 also propose a permanent provision.
consistent with a policy of minimizing adverse consequence associated with loan
renegotiations in the short-term.
It could also be argued that the temporary exclusion of residential COD income
is preferable because owner-occupied housing is already heavily subsidized even
without a COD exclusion. Three principal tax provisions for owner-occupied housing
currently exist in the tax code. The deduction for mortgage interest is the most costly
provision, with an estimate of $79.9 billion in revenue loss for FY2008.26 The
exclusion of gain on the sales of homes is the second largest tax provision for
homeowners, with an estimate of $29 billion in tax revenue loss for FY2008.27 The
deduction of state and local real estate taxes is the third provision, with an estimate
of $14.3 billion in tax revenue loss for FY2008.28 Some economists feel that this
preferential tax treatment encourages households to overinvest in housing and less
in business investments that might contribute more to increasing the nation’s
productivity and output.29
On the other hand, some analysts might argue that the provision should be
permanent. A case could be made that a temporary provision is unfair because there
is no difference between an individual experiencing canceled debt income in 2008,
when foreclosure rates may be high, relative to three or four years from now, when
foreclosure rates may be lower. If the policy purpose is to minimize hardship when
taxpayers experience distress, then making the provision permanent would seem
consistent with that purpose.
What Types of Canceled Debt?
Several options are possible in determining what type of canceled mortgage debt
income may be excluded from taxation. The broadest modification would allow all
canceled residential debt to be excluded from income. Currently, only debt associated
with the primary (or principal) residence of a taxpayer may be excluded, rather than,
for instance, a vacation home or investment property.30
Some policy analysts have suggested disallowing second liens as qualified
residential debt. Second liens are not directly ineligible for the exclusion, although
currently, qualified debt is restricted to include debt incurred in acquiring,
constructing, or substantially improving the taxpayer’s principal residence.
26 U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for
Fiscal Years 2007 to 2011, JCS-3-07 (Washington: GPO, 2007), p. 27.
29 N. Edward Coulson, “Housing Policy and the Social Benefits of Homeownership,”
Business Review - Federal Reserve Bank of Philadelphia, Second Quarter 2002, p. 8.
30 As mentioned previously, H.R. 1876/S. 1394 limits the exclusion to the residence of the
taxpayer, but not the principal residence; H.R. 3506 limits the exclusion to the principal
For some individuals, second liens may be home equity lines of credit, for
others, second liens may be debt incurred as part of the purchase of the home. To the
extent that home equity lines of credit are used to enhance the home and make capital
improvements, it may be consistent with stated policy goals to include this debt as
eligible for the exclusion. Yet, home equity lines of credit can also be used to finance
consumption, such as vacations or paying off other debt. It may not be consistent
with policy goals, some might argue, to include this type of debt in the exclusion.
Congress may also wish to consider changing the limit on the amount of
canceled debt that can be excluded from income. P.L. 110-142 imposed a limit of
$2 million ($1 million if married filing separate returns). Increasing the limit would
likely increase revenue loss associated with the exclusion, while decreasing the limit
would have the opposite effect. Decreasing the exclusion limit might also reduce the
benefit to upper income taxpayers.
Which Homeowners Should Be Eligible?
Policy makers could limit the ability of homeowners to exclude canceled debt
income according to certain eligibility requirements.
Ownership Tenure. The exclusion for canceled debt income could be limited
to homeowners who meet ceratin ownership and/or use tests. For example, a
homeowner must meet both an ownership and use test in order to claim the exclusion
for gain on owner-occupied housing that is available under IRC § 121. The
ownership test requires the taxpayer to have owned the house for two of the last five
years, while the use test requires the owner to have lived in the house for at least two
years out of the last five years. Limiting the exclusion of capital gains in this manner
was designed to minimize the possibility that investors, rather than owner-occupants,
would be able to exclude capital gains from taxation. Alternatively, it could be
argued that tenure is not relevant to the stated policy goals of mortgage debt
If an ownership and/or use test were applied to an exclusion of COD income,
the number of tax filers eligible to claim the exclusion might be reduced. This
reduction in filers may result in lower revenue loss. This policy option would also
add complexity to the reporting and filing processes and thus the tax code.
Household Income. Some policy makers have suggested that foreclosure
assistance be provided only to households with low and moderate incomes.31 As with
other housing tax incentives, such as the mortgage revenue bond program and the
first-time homebuyer tax credit for District of Columbia residents, income levels
could be capped and the exclusion made unavailable to those households with
income above the ceiling set by the legislation. It would seem that income would be
highly correlated with foreclosure, in that those with lower income are experiencing
hardship. Regardless of whether this is borne out by the data, it could be argued that
household income is not relevant to the stated policy goals for the legislation.
31 H.R. 3506 proposes a limit of $100,000 for the household income of eligible taxpayers
($200,000 for married taxpayers filing jointly).
This option could reduce the revenue loss associated with the provision, but
would add complexity to the administration and tax filing process, relative to an
exclusion without such a restriction.
Should Basis Be Adjusted?
As discussed above, current law requires that taxpayers who exclude COD
income must essentially give back some of benefit by reducing tax attributes, such
as basis in property. Several policy issues arise from this rule. The first is which tax
attributes, if any, should be adjusted to account for excluded canceled mortgage debt
income. One option is that there be no attribute reduction requirement. Alternatively,
homeowners could be required to reduce specified tax attributes that include, but are
not limited to, basis in the residence (e.g., taxpayers would be able to reduce basis in
property other than the home subject to the discharged mortgage). A third option
would be to require basis reduction in the taxpayer’s residence. All taxpayers would
benefit from the first option by not having to account for the excluded COD income.
Whether a taxpayer would prefer the second option over the third one would depend
on his or her circumstances (e.g., whether the taxpayer has basis in other property that
would have to be reduced in the event of insufficient basis in the residence). The
temporary exclusion of COD income enacted by P.L. 110-142 uses the third option
— homeowners are required to reduce basis in the principal residence to account for
the excluded COD income.
Another issue is when tax attributes should be adjusted. If basis is adjusted, one
option could be to make the proposal consistent with current law, under which basis
adjustment occurs in the year following discharge of the debt. Alternatively, basis
adjustment could occur earlier (e.g., at the time of discharge or exclusion). If basis
adjustment occurred in the year after discharge, homeowners losing their home at the
time of debt cancellation would have already disposed of the property.
The requirement that a basis adjustment in the amount of cancelled debt
suggests a desire by policymakers for homeowners to have to account for the benefit
of the cancelled debt. Basis adjustment results in the taxation of cancelled debt
income to the extent that gain from the disposition of the home is taxable; however,
the timing of the basis adjustment may result in different tax consequences for
taxpayers who lose their home.
The exclusion of COD income may result in differential treatment of taxpayers
depending on basis adjustment timing, eligibility for exclusion of gain from the
disposition of the residence, and homeownership retention. Policymakers may wish
to account for that differential treatment, although doing so may add complexity and
administrative cost to the proposal relative to its current state.