Do you own a second home on the Cape? Watch out for HR3648.

Watch out for important news from Washington D.C. As of a couple of weeks ago, the House has agreed to legislation that would provide tax relief when lenders forgive some portion of a mortgage debt. The vote was 386-27. Under current law, forgiven mortgage debt is treated as taxable income and taxed at ordinary income rates. The legislation would provide a permanent rule that eliminates the requirement to pay tax on forgiven mortgage debt on a principal residence, up to $2 million. There is no income restriction on those who are eligible for the relief.

This has been a long awaited step by many people who were having trouble selling their homes for the amount of the mortgage balance, and were instead looking to do a "short sale" with their lender. Under the current law, if you owe your bank $300 K, and they agree to accept $250 K, the remaining $50 K difference is treated as "taxable income"

to you. This fell under the long-standing provision known as "forgiveness of debt" tax.

To many families facing bankruptcy or foreclosure, the "forgiveness of debt" tax has always been a feared spirit out on the horizon. Of course, one might look at it from a completely different standpoint, and surmise that it also provided an incentive, perhaps a "golden handcuff" to ensure that even people with no equity left in a property,

still had some "skin in the game" and a reason not to just totally walk away from the property. Personally, my fear is that the government may want to focus on ways to actually keep people in their homes, and making their payments … perhaps along the lines of the FHA refinancing program. Removing all obstacles to just "walking away" and handing the keys back to the bank may have just the opposite effect, and depress the market even further by saddling banks with defaulted properties.

Paying for the elimination of this "forgiveness of debt" tax relief will cost close to $2 billion of the next 10 years … and if you've got a second home that money will potentially be coming from you and your family.

In order to "pay for" the mortgage cancellation relief, the Ways and Means Committee modified, but did not eliminate, a tax planning opportunity for owners of vacation and rental properties. Under current law, the owner of a vacation home or rental property may sell his/her principal residence, exclude up to $500,000 of the gain from taxation, and then convert the second property into his/her principal residence. Once the two-year residency requirement has been satisfied, the individual may sell that property and once again exclude as much as $500,000 from taxation.

The new rule modifies the application of the exclusion when an individual converts a rental or vacation property to his/her principal residence. Under the new rule, effective Jan. 1, 2008, the owner will still have the option of receiving the benefit of the exclusion, but will be required to pay capital gains taxes on the appreciation attributable to the time that the property was used as an investment property. The amount excluded will be a fraction, determined at the time the vacation/rental property is sold. Assuming that the owner has satisfied the two-year residence requirement, the amount of gain that can be excluded will be determined by a fraction. The numerator of the fraction will be the number of years the property was used as a principal residence. The denominator will be the number of years the individual actually owned the property, measured from Jan. 1, 2008.

Other proposals circulated speak to changing the capital gains law on a primary residence. Under the current law, if you have lived in your home for two of the last five years, then the profits from the sale were free of capital gains up to 500K per couple. Under one proposal, the figure "five years" would be the key number to define a primary residence, and thus is you sold after three years, only 3/5ths of the profit would be free of tax.

Anyway … the bill still needs to make it through the Senate, and no clue yet whether or not the President will even sign it … but keep your eyes open, because whether you're thinking of a short sale, or doing estate planning and own a place on Cape Cod, HR3648 has something in there of importance to you.