The Congress's Christmas gift for the middle class: several last minute tax law changes that temporarily addressed the tax on forgiven mortgage debt and Alternative Minimum Tax (AMT).

If you don't want to be buried in the Congress's literature of the Tax Increase Prevention Act of 2007 and the Mortgage Forgiveness Debt Relief Act of 2007, you may read the excellent summary at CCH.

And here is the PFBlog analysis:

One-Year Band-Aid for Alternative Minimum Tax (AMT)

The problem our legislators need to resolve is simple: when they first introduced the Alternative Minimal Tax in 1970 to compel the riches to pay a minimal tax, they didn't allow for inflation adjustment in the amount of exemption. After that many years of inflation, the original exemption amount looks ridiculously low and, if adopted, will let AMT hit over 20 millions taxfilers who are normally considered as "middle class."

Both parties have agreement that this would be unfair, but in order to lift the exemptions for permanent inflation indexing, they need to find other sources of reliable revenue (read: assessing more tax elsewhere), and that's where it gets stuck.

It has been becoming an annual ritual that every year, both parties cannot agree on a long-term fix and can only end up with a temporary patch. What's different this year, is our Congressmen couldn't realize this until just before the Christmas, after IRS already printed out next year's tax forms and programmed its software according to the original law, and unfortunately people are now pointing fingers about who should be blamed for potential delays in tax return processing due to the last minute tax law change.

Mortgage Forgiveness Debt Relief

Unlike AMT, which is a long-term headache in the Capitol Hill, the taxation on mortgage forgiveness is a new problem for 2007, when the housing crash becomes more prevalent and pushing more families over the edge.

According to the tax law in the past, if your lender forgives a certain amount of your debt, that amount is considered taxable ordinary income to you. Question is: for debt-laden families, first, is it morally right to ask them to pay cash on the "phantom income?" And second, how can they find cash to pay the tax bill without falling deeper in the hole?

Technically, the tax on phantom income is not wrong -- debt forgiveness is a transfer of wealth and should be considered as income. However, our lawmakers feel the current situation is too bad for some (ex-)homeowners that they deserve to be rescued. Therefore, it is enacted that for the three years starting in 2007, up to $2 million debt discharge on debt that is secured by a principal residence will be exempt from income tax. In turn, taxpayers will have to reduce the "cost basis" of the property.

Now the PFBlog question is: can this new law introduce perverse behavior? Say, a bank invents a new mortgage product that charges higher-than-market interest rate, but promises to forgive certain amount of debt based on good payment behavior? This way, homeowners can get deduction on a larger amount of mortgage interest payment than they will otherwise have, but will pay off the debt at the same speed after they qualify for debt-forgiveness-with-good behavior?

Gladly, this time our Congress is smarter (compared to 1970) to close the loophole beforehand. The Mortgage Forgiveness Debt Relief Act of 2007 reads:

"EXCEPTION FOR CERTAIN DISCHARGES NOT RELATED TO TAXPAYER'S FINANCIAL CONDITION- Subsection (a)(1)(E) shall not apply to the discharge of a loan if the discharge is on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer."

At least they got it right once!