Tax Consequences of the Home Affordable Modification Program (HAMP) and the Treatment of Debt Discharge

Patricia Hughes Mills sets out ways in which distressed homeowners may be able to eliminate phantom taxable gain when debt is discharged--including participation in the Home Affordable Modification Program (HAMP) program.
Ms. Mills writes: 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. One component of this Plan – known as “HAMP” (the Home Affordable Modification Plan) – helps homeowners who have defaulted on their mortgage, or are at risk of defaulting, due to decreases in income or other hardships. Under HAMP, 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. Each month that a homeowner makes a mortgage payment on time, the homeowner accrues an amount toward a Pay-for-Performance Success Payment. A payment of the accrued amounts is made annually, to reduce the principal balance on the homeowner’s mortgage loan. Homeowners can receive principal reductions of up to $1,000 per year for up to five years, such to a de minimis threshold.

What are the tax consequences of HAMP payments? Normally, the discharge of indebtedness is taxable income. Certain exceptions are provided when the discharge occurs in bankruptcy, when the taxpayer is insolvent, and when the debt is qualified farm indebtedness, qualified real property business indebtedness, or qualified principal residence indebtedness (more about this below). The HAMP payments, however, are not traditional debt discharge, but rather a payment made by another party to reduce the homeowner’s mortgage balance. Payments made on behalf of a taxpayer are generally also income to a taxpayer. 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.

(Non-HAMP) Discharge of Indebtedness

Examples of (non-HAMP) debt discharge affecting homeowners. Outside of the HAMP program, homeowners may also face discharge of indebtedness either by a foreclosure on their property or by negotiating with the lender for a modification of their home loan. For example, homeowners in a foreclosure may have debt relief in the amount of the difference between the adjusted issue price of the debt being cancelled and the amount used to satisfy the debt (typically the value of the residence). Thus, where a lender forecloses on a home currently worth $180,000 in satisfaction of an outstanding loan balance of $200,000, the taxpayer has $20,000 of debt relief. Similarly, if instead of foreclosure that creditor agrees to restructure the loan and reduce the principal amount to $180,000, the homeowner has $20,000 of debt relief. [footnotes omitted]
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