Lots of questions have arisen from people since President Bush signed into law the Mortgage Forgiveness Debt Relief Act of 2007, whereby in certain circumstances, a homeowner does not have to pay federal income tax on debt forgiven on a loan secured by a qualified principal residence via a short sale, foreclosure, deed in lieu, loan workout or short refinance where the loan amount was reduced and forgiven in order for the homeowner to keep the property.

It is somewhat confusing just reading a bill with only references to other sections of the law. Below is the text of Section 2 of H.R. 3648 that specifically pertains to mortgage forgiveness. To save you the hassle of cross-referencing all this, I have included the sections of the IRS Tax Code that were added to or modified as a result of Section 2 of H.R. 3648.

SECTION 1. SHORT TITLE.

This Act may be cited as the ‘‘Mortgage Forgiveness Debt Relief Act of 2007’’. SECTION 2. DISCHARGES OF INDEBTEDNESS ON PRINCIPAL RESIDENCE EXCLUDED FROM GROSS INCOME.

(a) IN GENERAL. Paragraph (1) of section 108(a) of the Internal Revenue Code of 1986 is amended by striking ‘‘or’’ at the end of subparagraph (C), by striking the period at the end of subparagraph (D) and inserting ‘‘, or’’, and by inserting after subparagraph (D) the following new subparagraph: ‘‘(E) the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2010.’’.

(b) SPECIAL RULES RELATING TO QUALIFIED PRINCIPAL RESIDENCE INDEBTEDNESS. Section 108 of such Code is amended by adding at the end the following new subsection:

‘‘(h) SPECIAL RULES RELATING TO QUALIFIED PRINCIPAL RESIDENCE INDEBTEDNESS.—

‘‘(1) BASIS REDUCTION.—The amount excluded from gross income by reason of subsection (a)(1)(E) shall be applied to reduce (but not below zero) the basis of the principal residence of the taxpayer.

‘‘(2) QUALIFIED PRINCIPAL RESIDENCE INDEBTEDNESS.—For purposes of this section, the term ‘qualified principal residence indebtedness’ means acquisition indebtedness (within the meaning of section 163(h)(3)(B), applied by substituting ‘$2,000,000 ($1,000,000’ for ‘$1,000,000 ($500,000’ in clause (ii) thereof) with respect to the principal residence of the taxpayer.

‘‘(3) EXCEPTION FOR CERTAIN DISCHARGES NOT RELATED TO TAXPAYER’S FINANCIAL CONDITION.—Subsection (a)(1)(E) shall not apply to the discharge of a loan if the discharge is on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer.

‘‘(4) ORDERING RULE.—If any loan is discharged, in whole or in part, and only a portion of such loan is qualified principal residence indebtedness, subsection (a)(1)(E) shall apply only to so much of the amount discharged as exceeds the amount H. R. 3648—2 of the loan (as determined immediately before such discharge) which is not qualified principal residence indebtedness.

‘‘(5) PRINCIPAL RESIDENCE.—For purposes of this subsection, the term ‘principal residence’ has the same meaning as when used in section 121.’’.

(c) COORDINATION.

(1) Subparagraph (A) of section 108(a)(2) of such Code is amended by striking ‘‘and (D)’’ and inserting ‘‘(D), and (E)’’.

(2) Paragraph (2) of section 108(a) of such Code is amended by adding at the end the following new subparagraph: ‘‘(C) PRINCIPAL RESIDENCE EXCLUSION TAKES PRECEDENCE OVER INSOLVENCY EXCLUSION UNLESS ELECTED OTHERWISE. Paragraph (1)(B) shall not apply to a discharge to which paragraph (1)(E) applies unless the taxpayer elects to apply paragraph (1)(B) in lieu of paragraph (1)(E).’’.

(d) EFFECTIVE DATE. The amendments made by this section shall apply to discharges of indebtedness on or after January 1, 2007.

The following are the sections of the IRS Tax Code that were added to or modified as a result of Section 2 of H.R. 3648. Anything that was to be deleted is still there, but with a strikethrough. Additions are highlighted in yellow.

Section 108. Income from discharge of indebtedness (a) Exclusion from gross income

(1) In general

Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if -

(A) the discharge occurs in a title 11 case,

(B) the discharge occurs when the taxpayer is insolvent,

(C) the indebtedness discharged is qualified farm indebtedness, or

(D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness. , or,

(E) the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2010. (2) Coordination of exclusions

(A) Title 11 exclusion takes precedence

Subparagraphs (B), (C), and (D) of paragraph (1) shall not apply to a discharge which occurs in a title 11 case.

(B) Insolvency exclusion takes precedence over qualified farm exclusion and qualified real property business exclusion

Subparagraphs (C) and (D) , (D) and (E) of paragraph (1) shall not apply to a discharge to the extent the taxpayer is insolvent.

Section 108. Income from discharge of indebtedness (h) Special rules relating to qualified principal residence indebtedness

(1) Basis reduction

The amount excluded from gross income by reason of subsection (a)(1)(E) shall be applied to reduce (but not below zero) the basis of the principal residence of the taxpayer.

(2) Qualified principal residence indebtedness

For purp

oses of this section, the term ‘qualified principal residence indebtedness’ means acquisition indebtedness (within the meaning of section 163(h)(3)(B), applied by substituting ‘$2,000,000 ($1,000,000’ for ‘$1,000,000 ($500,000’ in clause (ii) thereof) with respect to the principal residence of the taxpayer.

(3) Exception for certain discharges not related to taxpayer's financial condition

Subsection (a)(1)(E) shall not apply to the discharge of a loan if the discharge is on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer.

(4) Ordering rule

If any loan is discharged, in whole or in part, and only a portion of such loan is qualified principal residence indebtedness, subsection (a)(1)(E) shall apply only to so much of the amount discharged as exceeds the amount H. R. 3648—2 of the loan (as determined immediately before such discharge) which is not qualified principal residence indebtedness.

(5) Principle residence

For purposes of this subsection, the term ‘principal residence’ has the same meaning as when used in section 121.

Two key terms require defining within the context of the Code.

Principal residence is defined in this link to Section 121 .

is defined in this link to Section 121 Acquisition indebtedness is defined in Section 163 cited below.

Section 163(h)(3)(B)

(B) Acquisition indebtedness

(i) In general

The term ''acquisition indebtedness'' means any indebtedness which -

(I) is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and

(II) is secured by such residence.

Such term also includes any indebtedness secured by such residence resulting from the refinancing of indebtedness meeting the requirements of the preceding sentence (or this sentence); but only to the extent the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness.

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