The Tax Implications Of The Mortgage Forgiveness Debt Relief Act

By Carla Turchetti. May 7th 2016

In the past, homeowners who received relief from mortgage debt through a loan modification or a debt forgiveness program found themselves indebted to the Internal Revenue Service.

Like pouring salt in an open wound, the tax code has historically treated many forms of canceled mortgage debt as income, forcing the IRS to tax those who had benefited from debt forgiveness. Ironically, the very tactics used to rescue a homeowner from unmanageable mortgage debt often resulted in a hefty tax bill he or she could not afford. In fact, even those who lost their homes to foreclosure but had some or all of their mortgage debt forgiven were handed a large tax bill.

The Mortgage Forgiveness Debt Relief Act of 2007 was designed to remedy the conflicting rules of debt forgiveness by providing tax relief for homeowners who had lost their properties to foreclosure or had restructured their mortgage by reducing the total amount of money owed. The goal of the act was to create an incentive for homeowners and lenders to work together to restructure mortgages and keep families in their homes. However, there are limits and prerequisites for homeowners and lenders to qualify for the program, which is set to expire in December. Homeowners looking at debt forgiveness as a light at the end of the tunnel should do their homework before they are surprised with a tax bill they didn't anticipate and can't afford.

What Is Cancelled Mortgage Debt?

Cancelled or forgiven mortgage debt occurs when a mortgage lender forgives an unpaid balance on a mortgage loan. For example, if a homeowner took out a $200,000 mortgage from a bank and was only able to repay $100,000 and defaulted on the remaining balance, the bank can forgive the remaining $100,000. Under U.S. tax law, that $100,000 of forgiven debt is considered taxable income by the IRS.

The Mortgage Forgiveness Debt Relief Act prevents the amount of forgiven debt from being taxed for homeowners who:

  • Had their primary residence foreclosed on because they defaulted on their mortgage loan or
  • Restructured their mortgage loan to reduce the balance of the loan.

Who Qualifies For Tax Relief Under The Act?

Under the Mortgage Debt Relief Act, taxpayers can get tax relief on up to two million dollars of forgiven debt from the mortgage of a primary residence (or one million dollars for a married person filing a separate return).

Additionally, the money from the mortgage must have been borrowed to buy, build or substantially improve a primary residence. Forgiven debt from mortgages on second homes and rental properties does not qualify for the tax relief. Neither does the balance on a home equity loan that was used for something besides improving the home, such as paying off credit cards, tuition bills or car loans.

Is This Tax Relief Permanent?

The legislation was passed by Congress in 2007 and was originally scheduled to end in 2009. The Emergency Economic Stabilization Act of 2008 extended mortgage debt forgiveness through the end of 2012. There is currently talk in Congress of extending the Act until 2015. However, this has not yet occurred.

Do You Have To Report Forgiven Mortgage Debt To The IRS?

Yes. The IRS requires that all forgiven mortgage debt be reported on a tax return through Form 982, the Reduction of Tax Attributes Due to Discharge of Indebtedness. The form is necessary for forgiven debt on both foreclosures and loans that were restructured.

How Does A Taxpayer Know The Exact Amount Of the Forgiven Debt?

Any lender that forgives mortgage debt of more than $600 is required to send the borrower a year-end 1099-C form, a Cancellation of Debt. The law requires that the 1099-C list the amount of the forgiven debt and the fair-market value of any foreclosed property.

Is Mortgage Debt Forgiven As Part Of A Short Sale Eligible For Tax Relief?

Yes. A short sale occurs when a property is sold for less than the amount remaining on the mortgage and the lender forgives the remaining mortgage balance. As long as the sold home was the borrower's principal residence, the forgiven mortgage debt is eligible for tax relief.

If you have had your primary home foreclosed on, you have recently sold your home in a short sale or you have done a mortgage modification to reduce your mortgage balance, you may be eligible for tax relief on any mortgage debt that was forgiven in the process. Doing your homework ahead of time could end up saving you thousands of dollars when tax season rolls around. Alternatively, falling asleep behind the wheel might lead to an unpleasant surprise when you get your tax bill from Uncle Sam.


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