Tax consequences of principal reduction addressed


The federal government has a number of programs designed to assist homeowners who are having difficulty making their mortgage payments or getting lenders to restructure mortgage loans.

One such program is the Principal Reduction Alternative offered in the Home Affordable Modification Program (HAMP-PRA), sponsored by the Department of the Treasury and HUD.

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Under this alternative, the principal of the borrower’s mortgage may be reduced over three years if the borrower satisfies certain conditions during a trial period. Until the effective date of a permanent modification, the terms of the existing mortgage loan continue to apply.

To encourage mortgage loan holders to participate in the program, the HAMP administrator makes an incentive payment to the loan holder for each of the three years in which the loan principal balance is reduced.

The IRS has addressed the income tax consequences to homeowners of participating in the principal reduction program in a recent revenue procedure (Revenue Procedure 2013-16). The owners may realize income from discharge, or forgiveness, of indebtedness if they wind up owing less on their mortgage loan.

Most homeowners should be able to exclude this income from their tax return if they use the home as their principal residence. This “principal residence exclusion” was recently extended to apply to discharge of indebtedness that occurs through Dec. 31, 2013. If the home is not used as the owner’s principal residence, an exclusion is available only if the owner can meet other, more stringent exclusions provided for in the Internal Revenue Code.

Unless an exclusion applies, the borrower must include in gross, or taxable, income the discharge of indebtedness income for the tax year in which the permanent modification occurs. However, the IRS will allow the borrower to choose to report the discharge of indebtedness under HAMP-PRA over a three-year period in some situations.

The investor incentive payments made by the HAMP administrator to mortgage loan holders are treated as payments on the mortgage loans by the U.S. government on behalf of the borrowers. If borrowers use the property as their principal residence, they exclude the payments from their gross income. If they use the property as a rental property, they include the payments in gross income unless some other exclusion applies.