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Canceled Mortgage Debt and Taxes

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Insolvency Exclusion for Canceled Debts
Debts canceled by a lender are presumed to be taxable income, unless an exception applies.

Home equity debt (not used to buy, build, or substantially improve a main home) and other types of canceled debt, such as credit cards, might qualify for tax-free treatment under the insolvency exclusion.

Insolvency happens when the debt liabilities exceed the fair market value of a taxpayer's assets. This will be the case with many people who have lost their home, since the market value of the home fell beneath the amount they owed on the property.

The IRS explains the insolvency exclusion in Publication 908:

"You are insolvent when, and to the extent, your liabilities exceed the fair market value of your assets. Determine your liabilities and the fair market value of your assets immediately before the cancellation of your debt to determine whether or not you are insolvent and the amount by which you are insolvent."

The insolvency exclusion amount is the amount of canceled debt that exceeds the fair market value of your assets. Let's say a taxpayer owns a house with a fair market value of $150,000 with an outstanding mortgage balance of $235,000, the person has no other assets, and home acquisition debt of $200,000. This person would have canceled debts of $50,000 (the loan amount minus the fair market value). Of this amount, $35,000 is equity debt (the amount not used to buy the home), and this amount could be excluded under the insolvency provision. The remaining $15,000 of debt would qualify for the mortgage exclusion. (Adapted from the example given in the Instructions for Form 982, page 4, ordering rule.)

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