A bill that would give homeowners facing foreclosure a tax break when lenders forgive part of their debt would make up for lost revenue by collecting more capital gains taxes on the sales of some second homes claimed as primary residences.

HR 3648, the Mortgage Forgiveness Debt Relief Act of 2007, would eliminate a provision of the tax code that allows the IRS to tax debt that’s forgiven as part of a foreclosure or loan modification as income.

That change — which is backed by the Bush administration — would reduce tax revenues by an estimated $1.38 billion over 10 years. HR 3648 would also extend the deduction for private mortgage insurance — scheduled to end this year — to 2014, at a cost of $570 million over a decade, and relax qualification tests for cooperative housing corporations, resulting in another $22 million in lost tax revenue.

To make up for the bill’s $1.97 billion impact on tax revenue over the next decade, it would also tighten the rules for counting a second home, vacation or rental property as a primary residence for tax purposes. Under current law, up to $250,000 (or $500,000 if married filing jointly) of the gain on sale proceeds from the sale of a primary residence are exempt from capital gains taxes.

As it stands now, homeowners can claim a home as their principal residence if they have lived there two of the five years before the sale. The bill would tie the size of the exemption to the period of time when it was actually used as a principal residence.

Tightening the capital gains tax exemption on second homes claimed as primary residences would raise an estimated $2 billion over the next 10 years.

The bill, which received unanimous approval Wednesday from the House Committee on Ways and Means, has the support of the National Association of Realtors and the National Association of Homebuilders.

Existing tax rules encourage homeowners who live in states with nonrecourse debt as the primary mortgage model to seek foreclosure over restructuring their loan with lenders, NAHB said in a letter to the committee. Homeowners who are solvent are also discouraged from seeking restructuring agreements from lenders, “a preferred situation for all involved,” NAHB said.

NAR said the bill would restore “fundamental fairness for homeowners in financial and economic distress” by eliminating taxes on the “phantom income” generated by foreclosures and workouts.

The group said it supports the proposed changes to the capital gains exemption on second homes claimed as primary residences to offset the resulting loss of tax revenue.

“The offset does not eliminate any tax benefit, but rather tightens the requirements for utilizing some tax benefits associated with the $250,000/$500,000 exclusion,” NAR said in a Sept. 25 letter to the committee. Owners of vacation homes or rental properties will still be able to convert their property into principal residences, the group said, but will no longer be able to utilize the exclusion as frequently as under current law.

The Mortgage Bankers Association said it supported the provisions of the bill that would allow for “limited exclusions” of classifying forgiven debt as income, and that extend the income tax deduction for all mortgage insurance premiums.

“While we support the Committee’s views with respect to the discharges of indebtedness on principal residences from gross income, we firmly believe that any tax code change must be done in a way that preserves incentives for borrowers to work with their lender on loss mitigation options and does not encourage foreclosures,” the MBA said. “We also caution that loss mitigation activities that result in debt forgiveness should be treated the same under the proposed tax exemption as debt that is discharged as a result of foreclosure, deeds in lieu of foreclosure or short sales.”

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