Tax Treatment of Canceled Debt and 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 might qualify for tax relief under the Mortgage Forgiveness Debt Relief Act, but only for a limited time.

First enacted in 2007, the Act was extended through 2016 and was set to expire or "sunset" on January 1, 2017. Bill H.R. 2543 was introduced in Congress in May 2017 to further extend the Act through 2018, but it has not yet passed. For the time being, at least, tax relief is available only for foreclosures or mortgage restructurings that occurred prior to January 1, 2017.

But if you qualified before that date and failed to claim this tax break, you still have a little time to file an amended tax return. You generally have three years from the date you first filed a return to amend it.

The Act allows you to exclude up to $2 million of debt forgiven or canceled by your mortgage lender on a main home. Both mortgage restructurings and foreclosures qualify. You can claim this tax relief by filing IRS Form 982 with your amended tax return. 

What Is Canceled Debt Income?

Anytime a lender cancels or forgives your debt, this is considered income to you and it's taxed accordingly. You accepted money which you were required to repay, and tax law considers that you effectively kept the money if you were unable to repay the debt. That makes it income—money coming into your household—so you must pay income tax on the amount unless an exception applies. 

The IRS has this to say about it:

"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."

Reporting Requirements 

Lenders must report debt forgiveness to the Internal Revenue Service using Form 1099-C, Cancellation of Debt, and the taxpayer should receive a copy of the form. This is your alert that your debt has been officially forgiven so you must include the amount on your tax return. You would enter it on line 21 of Form 1040 as "other income."

Mortgage Restructuring and Foreclosures

If you lost your home through foreclosure or restructured your mortgage for a lower balance from 2007 through December 31, 2016, you don't have to report the forgiven debt and you do not have to pay income tax on that amount thanks to the Mortgage Forgiveness Debt Relief Act. Discharged debt in 2017 could also qualify to be forgiven if there was a written agreement in 2016. 

Although this tax-free exclusion normally applies to canceled mortgage debt of up to $2 million, it's reduced to $1 million if you're married but file a separate return. The house must have been used as your main residence and the mortgage must have been taken out to buy, build, or make substantial improvements to the property. 

Some mortgage debt won't qualify for this tax-free exclusion, so forgiven debt associated with them would 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, as well as mortgages for second houses and rental properties.

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 ... The exclusion does not apply if the discharge is due to services performed for the lender or foe any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition."

Other Tax-Free Exclusions 

Although the fate of the Mortgage Forgiveness Debt Relief Act remains uncertain, the tax code provides other ways that canceled debt can be tax-free so all isn't lost. 

Canceled debts do not have to be included in taxable income if the debt was canceled in a bankruptcy case, if you were insolvent at the time the debt was forgiven, or if the canceled debt was intended as a gift. Certain business or farm property can also qualify for tax-free treatment.

The insolvency exclusion is particularly relevant because it often applies to borrowers with home equity loans or mortgages on second homes and rental properties. This insolvency provision can prove helpful to individuals who don't otherwise qualify for the Mortgage Forgiveness Debt Relief Act or if the Act is not renewed for future years. Insolvency means that your liabilities exceed the fair market value of your assets. It's that simple. This is often the case for borrowers whose properties have dropped in value and who must now restructure their loans or surrender their properties through foreclosure.