H.R. 3648: Mortgage Forgiveness Debt Relief Act of 2007

President Bush signed into law a new measure giving tax breaks to homeowners who have mortgage debt forgiven. Under preexisting law, the debt forgiven by a lender, such as for short sales and refinances, was generally taxable to the borrower as debt discharge income. With the passage of the Mortgage Forgiveness Debt Relief Act of 2007, a taxpayer does not have to pay federal income tax on debt forgiven for a loan secured by a qualified principal residence. This tax break applies to debts discharged from January 1, 2007 to December 31, 2009. Qualified principal residence indebtedness is debt incurred in acquiring, constructing, or substantially improving the residence (up to $2 million for refinances). For purposes of calculating capital gains, any debts discharged excluded from income under the new law must be subtracted from the basis of the taxpayer’s principal residence (but not below zero). However, taxpayers may generally exclude from capital gains income up to $250,000 (or $500,000 for married couples filing jointly) for properties owned and used as their principal residence for at least two of the last five years. For a copy of the Mortgage Forgiveness Debt Relief Act of 2007, go to http://www.govtrack.us/congress/bill.xpd?bill=h110-3648 With the new tax break for mortgage debt forgiveness law the government is limiting the capital gains exclusion. Currently, an individual could have lived in a principal residence for two years, and sell using the exclusion, move into their vacation home for two years, and sell using the exclusion, with the end result being that you could have a tax free gain of $500,000 THREE TIMES in six years. Now, for properties acquired and used as a second home starting next year, and later converted to principal residence for a time and then 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.

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1031 Exchange Strategies for the Long Term Investor

Section 1031 of the Internal Revenue Code is one of the most powerful wealth building tools available to investors. Section 1031 allows investors to defer payment of capital gains taxes on the sale/exchange of a business or investment property. 

The deferral of taxes means more purchasing power for the investor and the ability to more quickly build a better and larger investment portfolio. 

Building a Tax Snowball

Long term planning is crucial for investors planning a 1031 Exchange.  Although taxes can be deferred in an exchange they will not be forgotten.  The gain deferred in a properly structured 1031 Exchange will reduce the tax basis in the property acquired in the exchange. 

For example, let’s assume an investor with a $500K gain on the sale of a property can defer taxes by exchanging into a property with a net purchase price of $750K.  Generally, a property’s tax basis is the property’s net purchase price.  However, when exchanging, the gain will offset the basis, so in our example, the new basis is $250K.  A sale of the new property above $250K will result in a taxable event

If the investor has done several exchanges over the course of many years, they may face a large (and unexpected) tax liability when it is ultimately time to stop exchanging and “cash out”.  Therefore, it is of utmost importance that investors know how the tax laws work and plan appropriately.

Strategies for Avoiding Taxes over the Long Term

Proper planning can help minimize and potentially eliminate most taxes owed.  Investors can utilize two strategies to reduce their tax liability:

Convert To Primary Residence (Section 121 Strategy) - A 1031 Exchange investment property can be converted into a primary residence and upon disposition be eligible for the homeowners exemption.  This strategy can eliminate taxes on up to $500K of gain for married couples, or $250k for singles.  Converting an investment property into a primary residence can be tricky, so it is wise to consult with a tax advisor.  Although not a substitute for proper tax planning with an advisor, here are some helpful tips to consider.
Rental Income - Before being converted into a primary residence, the investment property should have reported rental income for at least 12 months so that the validity of the original 1031 Exchange is not challenged by the IRS.  12 months of rental activities should be considered a minimum, the more time held as a rental, the better.
Use and Ownership - Once converted into a primary residence the owner is not eligible for the homeowner’s exemption until the property has been owned for five years, and has been used by the owner as a primary residence for at least two out of the past five years.
Death (Estate Planning Strategy) - Upon death, owners of real property will pass the property on to heirs at a stepped-up tax basis.  With a new stepped-up basis, the capital gain earned during the decedent’s life is eliminated entirely.  A true death benefit provided by the tax code.  For estate planning purposes, many real estate investors choose to incorporate a “defer, defer, die” strategy.  Instead of cashing out and paying taxes, investors can 1031 exchange into easy to manage (or management free) properties that produce stable cash flow.  The property is held until the investor dies, leaving the asset to their heirs at a stepped up basis and eliminating the entire capital gains tax liability.

Popularity: 85% [?]