What is principal extinguishment?
Principal extinguishment is a growing trend among mortgage lenders, particularly secondary lienholders. Principal extinguishment is a negotiated agreement between the lender and the borrower whereby the lender agrees to release all of the remaining debt and satisfy the mortgage lien. In other words, the lender tells the borrower that they no longer owe any money and the lien will be removed.
May have to Pay IRS.
The borrower will likely receive a 1099C from the lender for the amount of the forgiven debt. The borrower may have to pay tax to the Internal Revenue Service (IRS) on the forgiven debt.
Different from Principal Reduction.
Principal extinguishment is slightly different than principal reduction. Principal reduction involves the removal of some of the underlying debt, but the borrower will still be responsible for the remaining debt. The mortgage lien will not be satisfied until the balance of the loan is paid in full.
The federal government’s Making Home Affordable Program has provisions known as the Principal Reduction Alternative and the Second Lien Modification Program. On June 3, 2012, the Department of the Treasury issued Supplemental Directive 10-05 announcing a Principal Reduction Alternative (PRA) regarding first lien mortgage loans. On October 15, 2011, Supplemental Directive 10-14 provided further guidance. Under PRA, lenders are eligible for financial compensation whenever they reduce mortgage principal under the Home Affordable Modification Program (HAMP).
The Second Lien Modification Program, announced on March 26, 2010 in Supplemental Directive 09-05, provides financial incentives for secondary mortgage lenders for a full extinguishment or a principal reduction if the borrower’s first lien was modified under HAMP guidelines.
The guidance in the Supplemental Directives does not apply to loans owned or guaranteed by Fannie Mae, Freddie Mac, insured or guaranteed by the Veterans Administration (VA) or the Department of Agriculture’s Rural Housing Service or insured by the Federal Housing Administration (FHA)