Principal Reduction Alternative in the Home Affordable Modification Program (HAMP) has IRS Consequences

Borrowers receiving aid under the HAMP–PRA program may report any discharge of indebtedness income either in the year of the permanent modification of the mortgage loan or ratably over the three years in which the mortgage loan principal is reduced on the servicer’s books.

Borrowers who exclude the “discharge of indebtedness income” must report both the amount of the income and any resulting reduction in basis or tax attributes on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

Financially distressed homeowners can apply for government help to lower their monthly mortgage payments, under the Making Home Affordable program. www.makinghomeaffordable.gov.
Under this program, the principal of the borrower’s mortgage may be reduced by an amount called the “PRA Forbearance Amount” if the borrower satisfies certain conditions during a trial period. The principal reduction occurs over three years.

If the loan is in good standing on the first, second and third annual anniversaries of the effective date of the trial period, the loan servicer reduces the unpaid principal balance of the loan by one-third of the initial PRA Forbearance Amount on each anniversary date. This means that if the borrower continues to make timely payments on the loan for three years, the entire PRA Forbearance Amount is forgiven.

To encourage mortgage loan holders to participate in HAMP–PRA, the HAMP program administrator will make an incentive payment to the loan holder (called a PRA investor incentive payment) for each of the three years in which the loan principal balance is reduced.

Guidance on Tax Consequences to Borrowers
PRA investor incentive payments made by the HAMP program administrator to mortgage loan holders are treated as payments on the mortgage loans by the United States government on behalf of the borrowers. These payments are generally not taxable to the borrowers under the general welfare doctrine.

Borrowers receiving aid under the HAMP–PRA program may report any discharge of indebtedness income either in the year of the permanent modification of the mortgage loan or ratably over the three years in which the mortgage loan principal is reduced on the servicer’s books. Borrowers who exclude the discharge of indebtedness income must report both the amount of the income and any resulting reduction in basis or tax attributes on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

If the principal amount of a mortgage loan is reduced by an amount that is more than the total amount of the payments made to the mortgage loan holder, the borrower may be required to include the excess amount in gross income as income from the discharge of indebtedness. However, many borrowers will qualify for an exclusion from gross income.

For example, you may be eligible to exclude the discharge of indebtedness income from your gross income reported on your income tax return if:
(1)  the loan is modified) before Jan. 1, 2014, and, the mortgage loan is qualified principal residence indebtedness, or,

 (2) the discharge of indebtedness occurs when the borrower is insolvent.

For additional exclusions that may apply, see Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals).

Details are in Revenue Procedure 2013-16 available on IRS.gov.