Some Mortgage Aid Recipients Hear from IRS

It was a common practice during the boom times: A single home would be refinanced time and again, perhaps spurred by a broker hungry for fees or a borrower looking to use his or her home for cash.

Now, homeowners in that situation who have managed to get mortgage help from their banks are often finding that they must pay federal income taxes on the mortgage aid.

Legislation originally passed in 2007 and renewed in January aims to protect people from facing such a liability after working out a loan modification or losing a home in a short sale. And in many cases it does.

But homeowners – including those receiving mortgage aid under last year’s $25 billion settlement with state attorneys general – may find that aid added to their tax liability if the mortgage relief applied to a refinancing or a home equity loan.

Data won’t be available for at least several years on how many people receiving mortgage help find themselves with a large debt to the Internal Revenue Service. But advocates say the tax laws are compounding the pain still being felt as the foreclosure crisis continues to unravel.

“There is a huge and growing problem out here,” said Mal Maynard of the Wilmington, N.C.-based Financial Protection Law Center. “Sometimes borrowers will lose their house in a short sale; they’ll think, ‘that was awful, but now the worst is behind me.’ ” Then they’ll hear from the IRS.

The federal government expects 5.6 million taxpayers to receive notice of debt cancellation income for the last tax year, up 12 percent from the year before. About $10.3 billion in forgiven debt was reported in the 2010 tax year, according to the IRS. Not all of that is mortgage debt, however.

The IRS rules determining whether that leads to a tax burden are complicated. In essence, mortgage relief is shielded from income tax only if it is on the original amount lent on a person’s primary residence.

As home prices rose during the late 1990s and early 2000s, millions of homeowners used the growing equity in their houses to refinance and take out cash. Some people essentially used their homes like an ATM. Other brokers targeted homeowners for serial refinancings to rack up fees, Maynard said.

Any homeowner in that situation who is now receiving mortgage relief could be subject to extra taxes. In 2006, a full 86 percent of refinances of loans held by Freddie Mac included taking cash out, data from the government-sponsored mortgage giant shows.

People also frequently took out home equity loans to pay off medical bills. Any reduction in those balances could be subject to tax.

“We’re fielding calls like this all the time,” said Joseph Bochicchio, a Charlotte, N.C. debt lawyer. He said many of his clients can be helped by filling out a form declaring insolvency, which can eliminate the tax burden.

In a more severe case, a homeowner can declare bankruptcy.