By Kenneth R. Harney
Saturday, October 6, 2007

In a tax-Peter-to-pay-Paul move, the House voted Thursday to permanently remove 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 House also voted to extend the tax 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.

To make up the lost tax revenue for those consumer-friendly changes, the House approved new restrictions on capital-gains-tax benefits available to people who buy second homes and later convert them to principal residences.

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.

Currently, if a house bought as a weekend retreat or vacation getaway is turned into a principal residence, the house qualifies for the full exclusion after the owners have lived in it for two years. The House bill would throttle back on that for future second-home purchasers. For properties acquired and used as second homes starting next year, and later converted to principal residences for a time and sold, only the period when the property was used as a principal residence will count toward the capital-gain-exclusion computation. The amount of the gain that's proportional to the period when it was not a principal residence would be taxable.

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

All second homes bought before 2008 would be grandfathered in, meaning that current rules will continue to apply to such homes that were used as second homes and later turned into principal residences.

Here's an example of how the change would work: Say a married couple buys a second home Jan. 1, 2008, and sold it Jan. 1, 2013, for a $500,000 gain, having lived in it as their principal residence during the final two years. Because the house didn't qualify as a principal residence for three of the five years of ownership, the couple would multiply the gain by three-fifths to determine how much of it is taxable -- in this case, $300,000.

The House Ways and Means Committee estimated that more than $2 billion in additional federal taxes would be raised in the coming 10 years as result of the change. That, in turn, would balance 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 mortgages, then lose their houses in foreclosures or short sales. A short sale is one where the proceeds are less than is owed. If the sale proceeds are not sufficient to retire the principal on the loan and the lender agrees to cancel the missing balance, the Internal Revenue Service treats the amount of forgiveness or cancellation of debt as taxable income.

Consider 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. You never pocketed that cash, you have lost whatever equity you had 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 bill, H.R. 3648, would exclude home mortgages from the tax code's "discharge of indebtedness" rules, retroactive to Jan. 1 of this year. Homeowners who fell behind on payments this year, lost their homes and had portions of their debt forgiven by lenders would be able to avoid the phantom tax. Owners who lost their homes in 2006 and earlier would not be eligible for relief.

The bill would also extend the deductibility of mortgage insurance premiums. Currently, Congress has authorized deductions only for premiums paid for loans closed during 2007. The bill would continue through 2014 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.

The bill now moves to the Senate for consideration, where a mortgage cancellation relief bill is pending before the Finance Committee. That bill, S-1394, lacks the House's capital gains changes affecting second homes but was cited favorably by President Bush recently.

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