I recently had a situation where an individual had bought their first house and took out their mortgage through Bank of America. The loan required a 3% down payment, but Bank of America granted her the funds to cover the 3%, meaning she didn’t actually have to put anything down on the mortgage.
When looking into this, I found that no down payment for first-time homebuyers is becoming common. In recent decades, a large portion of the state and city governments in the country have instituted their own down payment assistance programs that first-time homebuyers can apply for. In many of these programs, first time homebuyers are defined not only as individuals who haven’t owned a home, but individuals who perhaps did own a home at some point but haven’t owned one in the last 3 years. Many commercial lenders have now matched these programs for first-time homebuyers. Below is a brief overview of the two programs offered by two of the largest banks in the country, Wells Fargo and Bank of America:
- Wells Fargo has a program called NeighborhoodLIFT, which allows for up to $15K in down payment assistance.
- Bank of America has a program called “America Home Grant” which will cover non-recurring closing costs, up to $7,500. They also have a downpayment program that will cover up to 3% of the home purchase price, up to $10K max. [1]
Many of the state and local programs are 0% interest loans that must be repaid once you sell the house. Some programs provide for partial or full loan forgiveness as long as you live in the house for a certain number of years, typically 10-15 years. In contrast, the Bank of America down payment program is a grant, which means the homebuyer will keep the assistance regardless of whether they live in the house for 1 day or 100 years.
For tax purposes, Bank of America reports these funds on a 1099-MISC. [1] This will cause problems at tax time, because this form is used to report the transaction of money from one entity/individual to another, and is subject to income tax and possibly self-employment tax as well. So for tax purposes, the assistance will be viewed as if Bank of America had paid you the money directly with no stipulations, and you’ll end up paying the income and employment taxes typically associated with those forms of income. The amount of tax depends on your situation, but could be as high as 35-40%.
Why would Bank of America do that? Well, they admit that they do not know whether it’s taxable income or not, and advise recipients to consult a tax advisor. [1] This is a situation when having the right advisor can save you money.
Given that this is an area that does not have very much clarity from either the IRS or the courts, we cannot be certain of what is the correct way. We are forced to rely on statements made by the IRS and our own best common sense in reaching our conclusion. In determining whether downpayment assistance should be included in taxable income, we can rely on the following evidence:
- In a Question and Answer section of the IRS website, it states that downpayment assistance provided by a tax-exempt organization is not includable in the taxpayer’s income. Since the bank is a for-profit entity, this does not directly address the specific situation, but provides important context to how the IRS may view the taxability of downpayment assistance. [2]
- The flyer outlining the program terms and conditions issued by the bank states in the first footnote that the downpayment assistance is restricted to only being used on downpayment assistance and cannot be withdrawn as cash.
So, considering that:
- The taxpayer has no free choice in how they use the funds. They must use the funds in the way the bank directs them to, which is to reduce the mortgage.
- The taxpayer never actually receives physical funds into their bank account, nor take personal possession of the funds.
- The transaction involves two unrelated parties and arises from a related business transaction.
In our judgement, it is reasonable to assume that the transaction most accurately resembles a forgiveness of part of the debt, and not self-employment income to the taxpayer, nor a gift to the taxpayer. When you receive debt relief, IRS publication 551 page 6 outlines that the forgiven amount should be included in your gross income for tax purposes. [3] Therefore, Bank of America should have issued a Form 1099-C in the situation to show the cancellation of the debt, and not a Form 1099-MISC or 1099-NEC.
However, as of this writing, the amount of the cancelled debt can be excluded from your income if it meets the Qualified Principal Residence Indebtedness Exclusion (QPRIE) outlined in section 108(a)(1)(e) of the tax code. Qualified Principal Residence is defined in the instructions for IRS Form 982 as:
“Debt taken out to buy, build, or substantially improve your main home. The debt must also be secured by your main home” [4]
Since that is the case here, the income does not need to be included in taxable income in the current year. The taxpayer should report this exclusion by filing Form 982 with their tax return. Instead of reporting as income, the taxpayer will be required to reduce their basis in the home by the excluded amount. This means that when it comes time to sell the property, the excluded amount may be included as a gain on the sale of the home. However, many homeowners do not end up paying any gain on the sale of their main home due to another exclusion in the tax code, 121(a), which excludes the gain on the sale of a main home if the taxpayer used the property as their main home for at least 2 of the previous 5 years.
A couple of important things to note:
The first is that the QPRIE under section 108(a)(1)(e) is a long-standing “temporary” exemption to the tax code, not a permanent addition. This means that this exemption has been regularly extended by Congress, but may go away in future years. It is important to check and see what the latest status of this exemption is before filing.
Another important thing to note is that when you receive a Form 1099-MISC (or 1099-NEC), the bank sends one copy to you and one copy to the IRS. This means that the IRS computers will be looking for the income to be reported on the return. Many taxpayers advise clients in this situation to report the 1099 on Schedule C, and list an equal amount as an expense on Schedule C. However, in this particular situation, this is most likely not the correct way to do it, and could subject you to accuracy related penalties if the IRS were to disagree with the position. The IRS approved way of handling the situation is to first reach out to the bank and ask them to retract the Form 1099-MISC and issue a Form 1099-C. If they disagree or if you never hear back from them, then you should file your return without listing the 1099-MISC on the return, and file Form 8275 with your return explaining the situation. This may delay the processing of your return, but it will give you more security that you will not be accessed any penalties if the IRS disagrees. The instructions for Form 8275 outlines that you will not be subject to accuracy-related penalties if the IRS determines that the exclusion of the 1099 was due to a “reasonable” position, which we feel is the case here.
Since the QPRIE is a federal law, different rules may apply for any state income tax return you may be filing. Many states use the Federal AGI as a starting point for their return, which means the exclusion will pass through to the state return as well. If you are in a state that does not use a federal starting point, then it’s important to see if there is a similar exemption on the books for your state. If not, you may be required to include the amount in your income for state purposes.
In summary, the downpayment assistance amount should not be reported as income on the federal return, but rather reported as a reduction in your basis of the home. This will require the filing of Form 982, which will be important to keep a record of when it comes time to sell the property down the road. Additionally, Form 8275 should be filed with the return to explain to the IRS why the 1099-MISC was not reported on the return. While this may delay the processing of the return, it provides strong assurance that you will not pay any accuracy-related penalties should the IRS disagree with the position.
If you find yourself in the same or similar situation and are looking to have your return filed the right way, we would be happy to help. Reach out to us here to get the process started.
[1] https://www.buildersshow.com/assets/docs/ibs/pressKits/PK_35501_BofACommunityHomeownershipCommitment.pdf
[2] https://www.irs.gov/charities-non-profits/down-payment-assistance-programs-assistance-generally-not-included-in-homebuyers-income
[3] https://www.irs.gov/pub/irs-pdf/p551.pdf
[4] https://www.irs.gov/instructions/i982
