Mortgage Relief Settlement Could Defray Tax Liability

As part of a recent settlement between Bank of America and the U.S. Department of Justice, almost seven billion dollars will be available to provide relief for homeowners struggling with “underwater” mortgages.

Forgiveness of substantial mortgage debt could however lead to large tax bills in April just as these homeowners are getting their heads above water. One portion of the settlement – approximately $490 million – will defray some of the tax liabilities. This post will discuss how the settlement could affect a typical borrower.

The Bank of America settlement creates a program that will reduce the principal of the borrower’s loan to 75 percent the value of the home. The interest rate would stay at a fixed two percent. These “principal reductions” are taxable events.

Here is an example of how the program works. A homeowner may have purchased a residence in 2006 for $275,000 and taken out a loan for $250,000. Assume that in 2014 the home is only worth $200,000 with a mortgage balance of $230,000. The program would write down the principal to $150,000. That $80,000 of forgiven debt is then a possible tax liability.

Failing to disclose a mortgage principal write down can invite an IRS audit along with penalties, interest and back taxes. However, the Tax Relief Fund set up in the settlement would offset the liability by providing 25 percent of the relief received up to $25,000.

In the past a tax credit spared homeowners from paying tax on forgiven mortgage debts. This credit expired in December 2013. Congress is considering a proposal to extend the tax break into 2014 and 2015. Unfortunately, it is included in a bill that has been delayed in a broader debate about tax reform.

Source: The Washington Post, “Some homeowners could get hit with a whooping tax bill if they accept help through Bank of America’s settlement,” Dina El Boghdady, August 21, 2014.