In a tax-Peter-to-pay-Paul move, the House voted last week to permanently remove what is called the “phantom income” tax penalty that haunts financially distressed homeowners whose debt is partially forgiven by a lender after a foreclosure or a “short sale” to avoid foreclosure.The measure, sponsored by Rep. Charles Rangel, D-N.Y., also would extend the deductibility of mortgage insurance premiums through 2014 - an important benefit for many borrowers who pay either private mortgage insurance or Federal Housing Administration premiums on their loans.

But to make up the lost tax revenue for these two consumer-friendly changes, the legislation imposes new restrictions on capital gains tax benefits available to people who buy a second home and later convert it to their principal residence. Under current rules, homeowners can exclude up to $500,000 (married joint filers) or $250,000 (single filers) on a property used as a principal residence for two out of five years.

If a house purchased as a weekend retreat or vacation getaway is turned into a principal residence, the house qualifies for the full exclusion on gains once the owners have lived in it for two years. The bill would reduce that for future second-home purchasers. For properties that are acquired and used as second homes after Jan. 1, and later converted to principal residences for a time and sold, only the period when the property was actually used as a principal residence will count toward the capital gains exclusion computation.

In effect, the change would prevent future second-home buyers from reaching back and receiving favorable capital gains treatment for periods of time when the property was not a principal residence, but a vacation property.

All second homes purchased before 2008 would be grandfathered under the bill; current rules will continue to apply to homes acquired prior to 2008 that were used as second homes and later turned into principal residences. The House Ways and Means Committee estimates that more than $2 billion in additional federal taxes would be raised during the coming 10 years as result of the change. That, in turn, will balance out the revenue losses caused by the phantom income and mortgage insurance provisions in the bill.

Here’s a quick summary of how those two other changes would work: Under current law, when a creditor forgives or cancels all or part of a debt, the amount forgiven is treated as ordinary income, taxable at ordinary rates. That is particularly harsh on homeowners who can’t pay their mortgage, then lose their house in a “short sale” or foreclosure. If the sale proceeds are not sufficient to retire their principal debt, and the lender agrees to cancel the missing balance, the IRS treats the forgiveness or cancellation of debt as taxable income.

Picture this scenario: To avoid foreclosure, you agree to sell your house to an investor for less than the amount you owe the lender. Say the shortfall is $20,000. If the lender cancels that balance as part of your negotiations, the IRS will demand income taxes on the $20,000 - even though you’ve never actually pocketed that cash, you’ve lost your equity in your house, and you are still reeling financially. It’s phantom income, but the IRS requires your lender to file a Form 1099-C reporting that it canceled your debt. Think of it as the tax code’s version of kicking you while you’re down.

The House bill, HR3648, would exclude home mortgages from the tax code’s “discharge of indebtedness” rules retroactive to Jan. 1. Homeowners who fell behind on payments this year, lost their houses and had portions of their debt forgiven by lenders will be able to avoid the phantom tax under provisions of the bill. Homeowners who lost their homes in 2006 and earlier will not be eligible for relief.

The bill would also extend the deductibility of mortgage insurance premiums for seven more years - through 2014. Currently, Congress has authorized only deductions for premiums paid for loans closed during 2007. The bill would continue the current limitations of full write-offs to households with adjusted gross incomes of $100,000 or less. Taxpayers with household incomes above $100,000 may qualify for reduced deductions.

Where is all this headed? The legislation will move to the Senate for consideration, where a mortgage-cancellation relief bill sponsored by Sen. Debbie Stabenow, D-Mich., is already pending before the Finance Committee. That bill, S1394, lacks the House’s capital gains changes affecting second homes.

The White House supports the tax measure but wants the mortgage relief to be in effect for three years, not the permanent status approved in the House. President Bush opposes limiting tax breaks on the sale of second homes.

Look for congressional action on some blended form of the two bills in the near future.

Source:

http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2007/10/07/RE94SHPUP.DTL