Phantom Taxable Gains and the Home Affordable Modification Program

The Obama Administration’s Homeowner Affordability and Stability Plan offers qualifying taxpayers the opportunity to refinance or modify home loans in order to avoid foreclosure. [Under] one component of this Plan - known as "HAMP" (the Home Affordable Modification Plan) - ... homeowners who make timely payments on their modified loans are eligible to have incentive payments made on their behalf by the federal government to their lenders.

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What are the tax consequences of HAMP payments? Normally, the discharge of indebtedness is taxable income... However, the I.R.S. has consistently held that payments made under legislatively provided social benefit programs for promotion of the general welfare are not includible in a recipient’s gross income. Consequently, the I.R.S. has ruled that the Pay-for-Performance Success Payments made under the HAMP program promote the general welfare by helping at-risk homeowners, meet the requirements of the general welfare exclusion, and therefore are not income to the homeowner.

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[T]he Mortgage Forgiveness Debt Relief Act of 2007 [the “2007 Act”]... now specifically excludes from a taxpayer’s gross income a discharge of qualified debt on a principal residence. Qualified principal residence indebtedness means acquisition indebtedness with respect to a taxpayer’s principal residence.  A taxpayer is entitled to relief from cancellation of indebtedness income of up to $2 million of qualified principal residence indebtedness under [IRC Sec. 108, as amended by the 2007 Act]. Note, however, that the relief provided by the 2007 Act applies to “acquisition” debt as defined in IRC Sec. 163(h)(3)(B), and not to home equity loans (unless those loans are used for substantially improving a principal residence and otherwise fit within the definition of acquisition indebtedness).

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Nonrecourse debt and foreclosure takes slightly different treatment. The treatment is slightly different when the homeowner is not personally liable for the home mortgage (i.e., the debt is nonrecourse) and the residence is transferred in foreclosure. [A loan modification of a nonrecourse debt will be eligible for the IRCSec. 108 exclusion described above, since that creates discharge of indebtedness income.] Where a property is transferred in satisfaction of a nonrecourse debt, the transaction is treated as a sale of the property for the full amount of the debt, resulting in gain or loss to the extent that the debt is greater than or less than the basis of the property. There is no discharge of indebtedness income since the entire debt amount is an amount realized in a sale.

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