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Lock in new mortgage law tax breaks: 3 key changes

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in Small Business Tax

Reacting to the subprime mortgage crisis, Congress passed the Mortgage Forgiveness Debt Relief Act late in 2007.

Alert: The new law’s centerpiece is a tax exclusion for beleaguered debtors. But it also contains additional tax breaks for homeowners, particularly surviving spouses.

Here’s a quick summary of three key changes:

1. To forgive is divine. Normally, income realized by someone due to a discharge of debt constitutes taxable income, unless an exception applies. Generally, the taxable amount is the difference between the debt’s principal balance and the amount used to satisfy the debt.

Under the new law, the first $2 million of mortgage debt forgiveness on your principal residence is tax-free ($1 million for married taxpayers filing separately). You must reduce the amount of your basis in the home by the excluded amount, but not below zero.

This new tax exclusion does not apply if the discharge isn’t directly related to a decline in the property’s value or your financial condition. Also, this option isn’t available to taxpayers in a Title 11 bankruptcy.

Tip: The tax break is limited to the debt on your main home. It can’t be claimed for a vacation home. The forgiven debt must have been used to acquire, construct or improve a taxpayer’s principal residence.

2. Keep deductions for mortgage insurance. Prior to the new law, Congress had approved a one-year deduction for qualified mortgage insurance premiums. You can deduct those premiums on your 2007 return if your AGI didn’t exceed $100,000. A partial deduction is available for an AGI of up to $109,000. To qualify, the mortgage insurance contract had to be issued after 2006.

The new law extends this tax break for three more years through 2010.

Tip: Now you may be able to claim deductions for qualified mortgage interest premiums paid or accrued before Jan. 1, 2011, for contracts issued after Dec. 31, 2006.

3. Maximize the home-sale exclusion. The home-sale gain exclusion is one of the biggest and best tax breaks on the books. You can pocket up to $500,000 ($250,000 for single filers) of tax-free gain on the sale of a home you’ve used as your principal residence for at least two out of the five years before the sale.

But the full $500,000 exclusion could be claimed only if a couple filed a joint tax return in the year they sold it. So, if a surviving spouse sold the home the year after the death of a spouse, the spouse is limited to the smaller $250,000 exclusion.

The new law allows a surviving spouse to take the larger $500,000 exclusion for a sale occurring within two years of the deceased spouse’s death (assuming the individual meets other tax-law requirements).

The new law features several other pro-taxpayer provisions, including a modified test for co-op tax benefits and a tax exclusion for emergency firefighters and medical responders.

Tip: The new tax breaks are offset by tougher penalties for failing to file partnership and S corp returns and higher estimated tax installments for large corporations in 2012.


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