How Is Canceled Mortgage Debt Taxed?

Learn if you qualify under the Mortgage Forgiveness Debt Relief Act

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Forgiven or canceled mortgage debt is generally considered income. However, people who lose their homes through foreclosure, or who have restructured their mortgage loans, might qualify for tax relief under the Mortgage Forgiveness Debt Relief Act (MFDRA), which was extended through the end of 2025 thanks to the Consolidated Appropriations Act of 2021.

The MFDRA was first passed by Congress in 2007 to provide tax relief for homeowners who had lost their properties. It allowed individuals to exclude certain canceled mortgage debt from their taxable income before it lapsed temporarily in 2018 and 2019. It’s now available again through 2025 and might be relevant for many homeowners impacted by unemployment and other financial hardships experienced over the last year.

The Mortgage Forgiveness Debt Relief Act

The MFDRA enabled taxpayers to exclude from their incomes certain mortgage debt that was canceled by lenders. A temporary measure at first (the law originally expired on Dec. 31, 2017), Congress gave it new life when it signed the Further Consolidated Appropriations Act of 2020 into law on Dec. 20, 2019. The act extended this mortgage forgiveness debt relief through Dec. 31, 2020. Congress extended it once again via the Consolidated Appropriations Act of 2021, this time through 2025, though with some changes.

Until the Consolidated Appropriations Act of 2021, certain canceled mortgage debt of up to $2 million—or $1 million if you were married and filing a separate return—could be excluded from income (this applies for tax year 2020). With the extension through 2025, the exclusion applies to certain canceled mortgage debt up to $750,000, or $375,000 if married filing separately, starting in tax year 2021.

When Does Canceled Mortgage Debt Become Income?

Forgiven or canceled debt is considered income. For example, maybe you’re going through a tough time and your friend gives you $100 to help you out. You promise to pay them back on your next payday, but they tell you not to worry about it. You now have $100 that you didn’t have before, even if you didn’t earn it through working. The IRS takes the position that this type of transaction represents income to you and it’s taxable. 

The same applies when a lender gives you money to purchase a home by extending you a mortgage. The remaining principal balance is considered to be income to you under the tax code if the bank forecloses and forgives what’s left of your loan because you no longer have to pay it back.

Any outstanding interest that’s not paid isn’t considered income because it isn’t taxable to you. 

You’ll most likely receive a Form 1099-C from your lender, reporting the amount of debt that’s been canceled, and the IRS will get a copy of the form as well. You’re obligated to report that as income on your next tax return, unless you qualify for one of the exceptions.

There are two types of mortgage debt in the tax code: acquisition debt and home equity debt. Only acquisition debt may qualify to be excluded from taxable income. An acquisition debt’s proceeds are used to buy, build, or substantially improve a principal residence. Home equity debt is debt incurred where the proceeds were not used for these purposes.

All your debt will be acquisition debt if your only loan was the original mortgage used to buy the principal property. Only the outstanding balance on the original acquisition debt mortgages will count for refinanced loans. Part of your debt will be home equity debt if you did a debt consolidation refinance or took cash out, or if you had a home equity line of credit (HELOC) used for purposes other than to acquire a house. This debt will not qualify.

Let’s say you have an original mortgage of $200,000. You work with your mortgage lender to restructure the loan so that it is reduced to $180,000. That means $20,000 of the original mortgage debt was forgiven. This discharged debt is now considered taxable income, unless an exclusion applies.

Exceptions to the Rule

The MFDRA spells out specific circumstances under which an individual would not have to pay tax on canceled debts. These exceptions are called "exclusions." There are three reasons why canceled mortgage debt may be excluded from taxable income:

  1. The debtor was insolvent at the time of the foreclosure, short sale, or a loan modification that resulted in no longer owing the full balance due. Insolvency is when your debts exceed the value of all your assets.
  2. The debtor filed for bankruptcy.
  3. The canceled debt qualifies for the exclusion for certain types of debt, such as a non-recourse loan.

The house must also have been used as the taxpayer's main home or "principal place of residence,” so second homes, vacation homes, investment properties, or rental units don't qualify.

Claiming an Exclusion

The revived tax relief, known as the Qualified Principal Residence Indebtedness (QPRI) Exclusion, is something of a last-ditch escape hatch. The IRS indicates that you must claim at least one other exclusion first if you qualify for it, though you do have an either/or option with the other exclusion:

  • The bankruptcy exclusion would apply if you filed for bankruptcy protection under any of the options available under Chapter 11 of the federal Bankruptcy Code. This includes Chapter 7 and Chapter 13 for consumers.
  • The insolvency exclusion would apply if the total of all your debts exceeded the value of all your assets at the time of the cancellation of the debt. But home equity debt—that which wasn’t used to buy, build, or substantially improve the main home—and other types of canceled debt, suchas credit cards, might qualify for tax-free treatment under this exclusion.

You might need the help of a tax professional to calculate this accurately. The IRS offers an insolvency worksheet in Publication 4681 to help you get started. 

Reporting Canceled Debt on Your Tax Return

Report canceled debts on line 8 “other income” of Schedule 1, which goes with Form 1040, if they don’t meet one of the exclusions and are still considered taxable income.

Fill out Form 982 if you qualify to exclude some or all of the debt under the MFDRA, the insolvency exclusion, or the bankruptcy exclusion. Indicate which exclusion applies to you by checking the appropriate box under line 1. You may still receive a Form 1099-C listing this debt, even if it can be excluded, but you may not have to include it on your tax return.

Prepare Form 982 for each exclusion if more than one applies.