Gross Income Exclusion For The Discharge Of Indebtedness On Principal Residences

For most of the U.S., 2007 marked the beginning of the financial crisis and the rapid decline in the U.S. real estate market. During the first half of the decade, the lending market had begun issuing riskier mortgages with adjustable interest rates to individuals who could not qualify for conventional mortgages. The ease in which homeowners were able to secure these loans caused a greater demand for home ownership, and home builders were constructing new houses quickly to capitalize on the high demand.

These subprime, high-risk mortgages were financed with loans with lower interest rates and mortgage-backed securities. There were a disproportionately high number of these mortgages in existence and financial institutions were investing heavily in them. Since the beginning of the financial crisis, financial institutions have been widely criticized for failing to exercise due diligence in evaluating and balancing the risks associated with these investments and have been targeted as one of the largest contributors to the instability of the U.S. economy.

Rising interest rates caused many homeowners to default on their adjustable rate mortgages. The increased number of foreclosures along with the abundance of newly constructed houses produced an excess supply of homes, and housing prices began to decline as a result. Many homeowners were trapped with high-rate mortgages and the inability to refinance due to the decline in their homes' market value. Major global financial institutions suffered greatly due to their significant investment in what became worthless mortgage-backed securities. Concerns about the stability of the U.S. credit and financial systems led to stricter credit practices around the world and caused global investors to reduce their investment in the U.S. economy.

The Mortgage Forgiveness Debt Relief Act of 2007

As a result of the subprime mortgage crisis, the Mortgage Forgiveness Debt Relief Act of 2007 ("The Debt Relief Act") was passed to provide some relief to homeowners who fell victim to adjustable rate mortgages and the lending practices of large U.S. financial institutions. The Debt Relief Act was later extended by the Emergency Economic Stabilization Act of 2008. The Debt Relief Act provided an exception to the general rule under IRC Sec 61(a)(12) that requires the discharge of indebtedness to be included in a taxpayer's gross income. Discharge of indebtedness income is the difference between the outstanding loan balance prior to discharge and the amount paid to satisfy the debt. Prior to the passing of the Debt Relief Act, a taxpayer could only exclude debt discharge income from his gross taxable income if the taxpayer filed bankruptcy under Chapter 11 or when the taxpayer was insolvent. The Debt Relief Act added IRC Sec 108(a)(1)(E) which states that "qualified principal residence indebtedness" discharged after 2006 and before January 1, 2013 is precluded from a taxpayer's gross income. The income exclusion is limited to $2 million...

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