Mortgage Loan Modification and Your Tax Return

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Mortgage loan modification is a lender-approved change to your mortgage loan terms. If done right, mortgage loan modification will allow you to lower monthly payments and get a lower interest rate. However, this may result in more taxes. Until 2008, if the mortgage loan modification included mortgage loan forgiveness, you would have to pay taxes on the difference. The passage of Mortgage Forgiveness Debt Relief Act of 2007 changed that, forgiving your taxes if you modified the mortgage for your primary residence. If you own any other property, the old taxes still apply, but you may be able to use other tax breaks to reduce the resulting tax burden.

Understanding Mortgage Loan Modification

Theoretically, you can apply for mortgage loan modification any time you want. But in most cases, mortgage loan modification tends to come up when you start having trouble making payments. To the lender, this is a sign that you are in danger of going into default. This is something that the lender will want to avoid. When a borrower goes into default, the bank loses money. Even if it recovers some money through foreclosure, it would never be able to recover it all. This is why it would be willing to modify your loan, even if that comes at the expense of it's short-term profit.

Your mortgage loan can be modified in a number of ways. The lender may reduce your principle, interest, late fees, or some combination of all three. Since the lender does not want to lose money, it will compensate by increasing the loan term. This way, you would still owe lender the same amount of money - you will just have longer to repay it.

However, in some situations, the lender may be willing to reduce the total amount of money you owe. This is known as loan forgiveness. However, whatever benefit you get from the reduced balance is mitigated by the fact that it can lead to more taxes.

Mortgage Loan Modification and Loan Forgiveness

For tax purposes, loan forgiveness was traditionally seen as a form of profit. That's because, when part of your mortgage balance is forgiven, you get to keep some of the money you would otherwise have to spend. Because of this, the amount forgiven was traditionally taxed as a capital gain on the tax year when the loan modification was made.

Mortgage Forgiveness Debt Relief Act of 2007

The Mortgage Forgiveness Debt Relief Act of 2007 changed that situation. Under it's provisions, you do not have to pay taxes on forgiven loan balance if that mortgage loan was for your primary residence. The primary residence is a home where you live for the majority of the year. The only exception to this rule is if the total amount forgiven exceeds $2 million. Anything up to that point is tax-free. The rest is automatically taxable.

If you modified a mortgage for any property other than your primary residence, you will still have to pay the same taxes as before. Under the current law, Mortgage Forgiveness Debt Relief Act of 2007 will remain in force until the end of 2012. Unless the act is extended, you will have to pay taxes on all forgiven mortgage loan balance you get after that point.