Loan Mod or Debt Forgiveness

[erchess]

If a commercial lender modifies the terms of an underwater home mortgage or forgives debt in a short sale or foreclosure can the lender get a tax break or any other benefit from the Federal Government?

[Burke]

Would not it be a bad debt write-off on the tax return?

[snowshine]

We are talking about the debt instrument and its tax effects here, so we need to break down your scenario into different what ifs.

A loan modification is a reduction in the principal owed on a loan between the buyer and the original seller only. The lender must also be the seller. This usually only happens in self-financed sales, family sales, etc. In this instance, the interest income is reduced over the life of the debt instrument by the amount of debt reduction.

A short sale or foreclosure is actually a sale of the debt instrument. A loss here is treated as a capital loss and for a corporation is first carried back and then forward (someone please correct me if I have this screwed up).

A short sale or foreclosure for a related party would be a bad debt deduction.

Just thinking about this makes my head spin!

[appelman]

Isn't this an excessively restrictive definition of loan modification?

See, for example, this link:

http://www.hud.gov/offices/hsg/sfh/nsc/faqlm.cfm

[snowshine]

It is, but I'm thinking about non-payment of the principle of the loan. Loan modifications to the interest or payment schedules are a different animal entirely

[erchess]

Clarification

The lender is a bank or mortgage company. The house is in Virginia. I am under the impression that Uncle Sam at one time offered the lender a tax credit equal to the amount forgiven if the lender agreed with the home owner to reduce principal to or slightly below current FMV. My question is whether this was ever in place or did I hallucinate, and if it was in place is it still in place.

I have a client who is also a friend of my parents whose home that they moved out of over a year ago is under water and has not sold. The client is considering an absolute auction and I am encouraging him to consider other options. As I meditate and cogitate on the problem one thing that comes to my mind is how strong a position he's in if he tells the lender "either substantially reduce my principal NOW or I'm going to let you have the wretched house back and walk away."

[Zee]

Principal reduction

Joint Return AGI $300,000. Owes $300,000 on house with FMV of $300,000, few other liabilities. Somehow, TP received a $20,000 principal reduction. Go figure.