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Canceled Debt & Mortgage Forgiveness

Tax Relief for Foreclosures and Canceled Debts

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People who have lost their homes through foreclosure or who have restructured their mortgage loans may qualify for tax relief under the Mortgage Forgiveness Debt Relief Act.

Highlights of Mortgage Debt Relief

  • Exclude up to $2 million of debt forgiven or canceled by a mortgage lender on a main home.
  • Both mortgage restrucuring and foreclosures qualify
  • Available for the years 2007 through 2013.
  • Claim the tax relief using IRS Form 982 (PDF)

What is Canceled Debt Income?

Anytime a lender cancels, or forgives, your debt, that is considered income to the debtor. The tax laws considers this income, and the debtor is taxed on forgiven debt unless an exception applies.

Canceled Debt That is Taxable

Anytime a lender cancels or forgives debt, that is usually a taxable event. "Generally, if a debt you owe is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income." (Source: Publication 525.)

Debt forgiveness is reported by the lender using Form 1099-C, Cancellation of Debt. Individuals report the forgiven debt on their Form 1040, Line 21 as other income.

The tax laws provide several exceptions to the tax treatment of forgiven debts. Tax-free treatment of mortgage debt is the most generous and easiest to calculate.

Mortgage Restructuring and Foreclosures

Individuals who lost their homes through foreclosure will not have to pay income tax on the amount of mortgage debt that was forgiven or canceled. Tax-free treatment is also available to people who restructured their mortgages loans for a lower balance.

The tax-free exclusion applies to canceled mortgage debt of up to $2 million (or $1 million is married and filing a separate return). There are additional details to consider to qualify for this tax exclusion. The house must have been used as a main home, which means it was the principal place of residence for the debtor. Also, the debt must have been used to buy, build, or make substantial improvements to the residence.

Some mortgage debt won't qualify for this tax-free exclusion and will be considered taxable income. Mortgage loans that don't qualify include home equity loans where the proceeds were not used to buy, build, or improve the residence. Also, mortgages for second houses and rental properties do not qualify for the exclusion. However, some or all of this debt might qualify for other exclusions.

The IRS explains the tax break this way:

"The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

"This provision applies to debt forgiven in calendar years 2007 through 2013. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition." (Source: The Mortgage Forgiveness Debt Relief Act and Debt Cancellation, IRS.gov.)

Individuals who qualify for this tax relief will need to use Form 982 to report the canceled debt.

Other Exclusions for Canceled Debts

Besides the provision for mortgages on main homes, the tax code provides other ways that canceled debt can be tax-free. Canceled debts do not need to be included in taxable income if the debt was canceled in a bankruptcy case, if the individual is insolvent, or if the canceled debt was intended as a gift. Certain business or farm property may also qualify for tax-free treatment.

The insolvency exclusion is particularly relevant, as it will likely apply to borrowers with home equity loans or mortgages on second homes and rental properties.

This insolvency provision will prove helpful to individuals who don't otherwise qualify for the mortgage debt relief. To be considered insolvent, the person's liabilities must exceed the fair market value of their assets. This is will be especially true of borrowers who's properties have dropped in value and who now must restructure their loans or surrender their properties through foreclosure.

"A debtor is insolvent when, and to the extent, the debtor's liabilities exceed the FMV of the assets. Determine the debtor's liabilities and the FMV of the assets immediately before the cancellation of the debtor's debt to determine whether or not the debtor is insolvent and the amount by which the debtor is insolvent." (Source: Publication 908.)

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