The special rule for exclusion from income of cancellation of debt income related to the discharge of certain home mortgage debt (IRC §108(a)(1)(E)) was only extended by Congress through December 31, 2016 in the PATH Act. However, Congress did provide that the relief would apply to discharges after that date if certain events took place before December 31, 2016 that had the effect of entering into an agreement to cancel the debt at some later date.
In Notice 2016-72 the IRS provides guidance about how that “special rule” would apply to the Federal Housing Finance Agency’s (FHFA’s) principal reduction modification program (PRMP) and the Home Affordable Modification Program (HAMP).
The IRS details the special “in process” rule in the IRC as follows in the Notice:
Congress extended the relief under § 108(a)(1)(E) to arrangements entered into and evidenced in writing before January 1, 2017, in the Protecting Americans from Tax Hikes Act of 2015, Pub. L. No. 114-113, 129 Stat 2242, 3065-66 (2015) (PATH Act). Congress added this provision to protect a borrower-homeowner who is in the process of obtaining a permanent modification of the mortgage loan during 2016, although the permanent modification of the mortgage loan resulting in discharge of indebtedness would not occur until after 2016. For example, a borrower-homeowner who is in the process of obtaining a modified mortgage loan under the PRMP during 2016, because the borrower-homeowner is either in an active TPP or the mortgage loan servicer sends the borrower-homeowner a notice in conjunction with a TPP, might not complete the modification process until after 2016. The addition of § 108(a)(1)(E)(ii) by the PATH Act is designed to ensure that discharges of qualified principal residence indebtedness in these situations qualify for exclusion from income under that section.
The Notice outlines the requirements participants in these programs must meet to be able to take advantage of the IRC §108(a)(1)(E) exclusion for final discharges that take effect after December 31, 2016.
The Notice provides:
Qualified principal residence indebtedness is discharged "subject to an arrangement that is entered into and evidenced in writing before January 1, 2017" within the meaning of § 108(a)(1)(E)(ii) if: (1) before that date, a mortgage servicer sends a borrower-homeowner under the FHFA's PRMP a notice in conjunction with a written TPP or, for a borrower-homeowner in an active TPP, a separate notice in a written opt-out letter outlining the terms and conditions of the permanent mortgage loan modification following completion of the active TPP; (2) the borrower-homeowner satisfies all of the Trial Period and PRMP Conditions; and (3) the borrower-homeowner and servicer enter into a permanent modification of the mortgage loan on or after January 1, 2017. A similar conclusion applies to a TPP under HAMP®.
Advisers should remember that merely because a taxpayer has a discharge event after December 31, 2016 that fails to meet these requirements, other relief may be available. As the notice points out:
A discharge of indebtedness that does not qualify for the qualified principal residence indebtedness exclusion in § 108(a)(1)(E) may qualify for another exclusion, such as the insolvency exclusion under § 108(a)(1)(B) or the deductible debt exclusion under § 108(e)(2). For example, a cash basis homeowner generally would exclude from income under § 108(e)(2) the discharge of any accrued but unpaid interest on the mortgage for his or her principal residence to the extent the interest would have been deductible if paid. See Johnson v. Commissioner, T.C. Memo 1999-162, and Lawinger v. Commissioner, 103 T.C. 428 (1994). For more information about income from discharge of indebtedness, the qualified principal residence indebtedness exclusion, the insolvency exclusion, the deductible debt exclusion, and other exclusions from gross income that may apply, see Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals).