Tax Implications of Mortgage Modification

Mortgage modification changes the terms of your mortgage to enable you to afford your payments. If you've suffered a job loss, are on the verge of bankruptcy or are otherwise in danger of losing your home because you can no longer afford to make your payments, mortgage modification could save you by lowering your interest rate or writing off part of the money you owe on your mortgage principal. But mortgage modification has tax implications that might affect you.

Principal Reduction

If your mortgage holder agrees to wipe out part of the principal you owe — usually because of a decrease in the home's market value — the portion of the principal wiped out is a forgiven debt. Usually, the Internal Revenue Service treats a forgiven debt as income and taxes it accordingly. However, the Mortgage Forgiveness Debt Relief Act of 2007 allows you to avoid paying taxes on debt forgiven on the mortgage on your principal residence. If the debt forgiven is on a second home, you likely owe taxes on this amount. Even if you don't owe taxes on the forgiven debt, you must report the amount on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.

Lower Interest Rate

Your mortgage lender might also modify your mortgage by lowering your interest rate. This can result in a lower mortgage payment you can now afford. Because you're paying less interest, you'll also have a smaller interest write-off on your taxes than you might have had previously. However, because loan modification requires the lender to amortize the mortgage from the date you begin making your new payment, a larger portion of your new payment might go toward paying off the interest on the loan, so at least in the first years of the loan, you'll still have a large interest deduction for your taxes.

Longer Mortgage Term

Another way your lender might modify your mortgage is by extending the term of your mortgage to up to 40 years. This reduces the amount of your payment and could, too, result in a smaller interest write-off for your annual tax return, though you could be taking that write-off for more years with the longer mortgage term. As part of the modification process, the mortgage company re-evaluates your escrow account, which pays for insurance and taxes. If the value of your home has fallen, you might need less insurance, which could result in additional cost savings, and a slightly lower write-off for insurance on your tax return.

Eligibility

Not everyone is eligible for mortgage modification. To qualify for the government-backed program, you must have a first mortgage of less than $729,750 on your primary residence and have obtained your mortgage before Jan. 1, 2009. However, you might be able to negotiate a mortgage modification with your lender outside of the government program.

References

• IRS.gov: The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
• U.S. Department of Housing and Urban Development: Loan Modification Frequently Asked Questions
• U.S. Department of Justice: Making Home Affordable Program and Home Affordable Modification Program Frequently Asked Questions for Bankruptcy Filers
• Making Home Affordable: Explore Eligibility