A load modification is the result of a negotiation between a borrower and lender, typically over a large loan like a mortgage. Modifications help both sides compromise when the borrower cannot make the current monthly payments. This can save the borrower from foreclosure and credit damage, but the modification may also create tax complications.
Reducing Interest Rates
The borrower may be able to gain a modification that actually reduces interest rates on a loan. The lender still makes profit, but the monthly payments on the loan go down since a lower rate is applied to the principal each period. This is the key part of the modification process, because the monthly interest payments drop. When the borrower records interest payments on a tax return, this drop affects deductions.
In general, homeowners are able to deduct the interest payments they make on their monthly statements. But when the interest amount drops, the deduction drops as well, which means the borrower may have to pay taxes on a greater amount of income. Homeowners should carefully examine both itemized and standard deduction possibilities. It is possible that a standard deduction will save more money than an itemized deduction if the interest rate has been lowered enough.
Forgiven debt also affects taxes. Forgiven debt is the amount of money that the borrower would owe to the lender if the loan was unchanged. Sometimes loan modification results in debt settlement, in which the lender forgives a large amount of money. This money counts as income to the IRS and can create an extra tax burden when it comes time to pay taxes. Even the total money saved by lower interest payments may count as forgiven debt and be taxed.
The IRS responded to the housing market crash in 2007 and 2008 by creating exceptions to its forgiven debt rule, specifically designed to make it easier for homeowners to modify their loans. Borrowers who use the home as a primary residence and got their loan before 2007 may be eligible for this exception, which can help save money on taxes if the modification applies to the mortgage.