Guidance issued on tax treatment of National Mortgage Settlement payments

The IRS issued guidance on the correct tax treatment of payments taxpayers receive under the National Mortgage Settlement when their house is foreclosed on (Rev. Rul. 2014-2).

The National Mortgage Settlement is an agreement reached in 2012 between the U.S. government and the attorneys general of 49 states and the District of Columbia and five bank mortgage servicers to address abuses in mortgage loan servicing and foreclosures. As part of the settlement, a borrower payment fund was set up, which was intended to be a qualified settlement fund under Regs. Sec. 1.468B-1.

Under the settlement, the five mortgage servicers will pay approximately $1.5 billion into the fund, and the fund will make payments (National Mortgage Settlement payments) to borrowers whose principal residences were foreclosed on between Jan. 1, 2008, and Dec. 31, 2011. The payments are approximately $1,400 per loan.

The payments are designed to make up for the reduced proceeds borrowers realized in foreclosure because of the mortgage servicers’ allegedly unlawful conduct. The payments are not considered to be forgiven debt. The fund began making the payments last summer.

The ruling addresses four issues:

1. What is the proper tax characterization of payments from the National Mortgage Settlement fund?
2. If a National Mortgage Settlement payment is characterized as part of the amount realized on the foreclosure, and if that characterization creates or increases a gain on the foreclosure of the principal residence, does the taxpayer have grounds to exclude some or all of that gain from gross income?
3. If the property for which a taxpayer receives a National Mortgage Settlement payment contained one or more additional dwelling units that were not used as the taxpayer’s principal residence, how should the payment be allocated between the portion of the property that the taxpayer used as a principal residence and the rest of the property?
4. If a borrower who was eligible for a National Mortgage Settlement payment died before receiving it, what is the tax treatment of the person who receives that payment?

In addressing the first issue, the IRS ruled that the payments from the fund count as an additional amount realized on the foreclosure of the borrower’s residence. The amount realized is used to determine any gain or loss under Sec. 1001 and any gain that may be excluded under Sec. 121.

For the second issue, the IRS ruled that if the taxpayer includes a National Mortgage Settlement payment in the amount realized on the foreclosure of a principal residence and as a result creates or increases a gain on the foreclosure, the taxpayer may exclude the gain from gross income to the extent allowed under Sec. 121.

Regarding the third issue, since the payments are intended to compensate borrowers for the loss of a principal residence, the IRS ruled that if a taxpayer receives a payment for the loss of a multiple-unit property a portion of which was used as the taxpayer’s principal residence, then the entire payment is allocable to the portion of the property used as a principal residence.

Finally, the IRS ruled that a taxpayer who receives a deceased eligible borrower’s payment “stands in the shoes” of the borrower for purposes of determining the tax consequences of that payment, the ruling says, and any gain not excluded from gross income under Sec. 121 is income in respect of a decedent.

—Alistair Nevius (anevius@aicpa.org) is JofA editor-in-chief, tax.