Tax Treatment of Canceled Mortgage Debt
Lenders sometimes cancel or forgive debt in the form of unpaid balances. This relieves debtors of immediate financial stress, but it can potentially trigger a tax liability. Canceled debt is considered income to the debtor according to the IRS, and it's included as part of the debtor's taxable income. Some exceptions do exist, however, particularly with regard to mortgages.
Canceled Debt and Taxable Income
Tax law specifies that "income from discharge of indebtedness" is included in a person's gross income for the year and is subject to taxes. The rationale makes sense if you think about it. Party A gives Party B money that Party B didn't have before. Party B doesn't have those funds anymore when they pay the loan back, so the money isn't income. It's a different story if Party B gets to keep any portion of the funds that's forgiven.
Exceptions to the Rule
The law also spells out specific circumstances when a person will not have to pay tax on canceled debts. These are called "exclusions," which means the amount won't be included in a person's taxable income for a particular reason.
Three of them apply to canceled mortgages:
- The debtor was insolvent at the time of the foreclosure, short sale, or loan modification that resulted in no longer owing the full balance due.
- The debtor filed for bankruptcy protection.
- The canceled debt qualifies for the exclusion for certain types of mortgage debt.
Each of these exclusions has its own set of criteria and reporting requirements.
The Mortgage Forgiveness Debt Relief Act
Congress passed the Mortgage Forgiveness Debt Relief Act in December 2007 to provide tax relief for homeowners who've lost their properties. The law enabled individuals to exclude from tax certain mortgage debt that was canceled by lenders.
Unfortunately, this was a temporary measure, and the law expired on Dec. 31, 2017. Congress gave it new life, however, when the Further Consolidated Appropriations Act was signed into law on Dec. 20, 2019. The Act extended this mortgage forgiveness debt relief legislation through Dec. 31, 2020. Discharges of indebtedness occurring after Dec. 31, 2017 through the end of 2020 still qualify for this relief.
A number of criteria must nonetheless be met to qualify for this exclusion.
Canceled mortgage debt that doesn't meet these rules might still possibly be excluded from income using the rules for insolvency or bankruptcy.
It Must Be Your Principal Place of Residence
The house must have been used as the taxpayer's main home—it was the "principal place of residence" for the debtor. Second homes, vacation homes, investment properties, or rental units won't qualify under the Mortgage Forgiveness Debt Relief Act.
Limits on Discharged Debt
Canceled mortgage debt of up to $2 million—or $1 million if you're married married and filing a separate return—can be excluded from income under the mortgage forgiveness exclusion.
Acquisition Debt vs. Home Equity Debt
There are two types of mortgage debt in the tax code: acquisition debt and home equity debt. The Mortgage Forgiveness Debt Relief Act and, by extension, the Further Consolidated Appropriations Act, provides that only acquisition debt can be excluded from taxable income.
Acquisition debt is debt whose 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.
Separating out these two kinds of mortgage debt can be easy or complicated. How complicated the process will be depends on whether you refinanced your mortgage.
Calculating Your Forgiven Indebtedness
All of your debt will be acquisition debt if your only loans were the original mortgages used to buy the property. You can exclude up to the full $1 million or $2 million limit under the Mortgage Forgiveness Debt Relief Act.
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 used for purposes other than to acquire a house. This home equity debt will not qualify for the Mortgage Forgiveness Debt Relief Act.
Document the dollar amounts of this acquisition and home equity debt. A simple work paper might look something like this:
Purchase price of home: $200,000
$160,000 (first for 80% of home price)
$40,000 (second for 20% of home price)
$15,000 (home equity line to repair roof)
Total acquisition debt so far: $215,000
Refinanced all three loans into $235,000 loan
Balance of original acquisition debt loans was $200,000
Consolidating credit bills of $35,000
Total acquisition debt: $200,000
Total home equity debt: $35,000
People with home equity loans and cash-out or debt-consolidation refinance will have to do some extra bookkeeping to make sure they take full advantage of all the tax exclusions that apply to them. It can be crucial to gather original loan documents to show where the loan money was spent.
The Insolvency Exclusion for Canceled Debts
Home equity debt—that which wasn't used to buy, build, or substantially improve the 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 a taxpayer's debt liabilities exceed the fair market value of their assets. This will be the case with many people who have lost their homes because the market value of the home fell below the amount they owed on the property due to the economy. It includes all liabilities and all assets, however, not just the mortgage or mortgages.
Subtract the value of your assets from your total liabilities to determine the extent to which you're insolvent. The insolvency exclusion amount is the amount of canceled debt that exceeds the fair market value of your assets. You can only claim the amount by which you're insolvent.
Let's say a taxpayer owns a house with a fair market value of $250,000 with an outstanding mortgage balance of $335,000. The person has no other assets, and has home acquisition debt of $200,000. This person would have canceled debts of $85,000—the loan amount minus the fair market value.
Of this amount, $35,000 is equity debt—the amount not used to buy the home. This amount could be excluded under the insolvency provision. The remaining $50,000 of debt would qualify for the mortgage exclusion.
The Bankruptcy Exclusion for Canceled Debts
Canceled debts can be excluded from taxable income if the debts are forgiven as part of a bankruptcy proceeding. The taxpayer must have filed for bankruptcy and the debts must have been canceled at the order of the bankruptcy court.
It might be more advantageous to utilize the mortgage exclusion for acquisition debt and the insolvency exclusion for home equity and other types of canceled debt before considering a bankruptcy case, but it can depend on the extent of the taxpayer's other indebtedness.
Understanding Form 1099-C
A lender will submit Form 1099-C to both the IRS and to the homeowner whose debt was canceled or forgiven, reporting the amount of canceled debt in box 2 of the form. The amount shown is for the loan principal that was left unpaid for those who gave up their homes in a short sale, foreclosure, or another settlement process.
A description of the debt is shown in box 4, such as the address of the property. Box 7 of the form reports the fair market value of the property. In a foreclosure situation, the gross bid price from the foreclosure sale will be shown as the fair market value.
Reporting Canceled Debts on Your Tax Return
Report any canceled debts that are not excluded on line 8 of the 2019 Schedule 1 that goes with Form 1040. This is the line for "other income."
Fill out Form 982 if you qualify to exclude some or all of the debt under the Mortgage Forgiveness Debt Relief Act, the insolvency exclusion, or the bankruptcy exclusion. Indicate which exclusion applies to you by checking the appropriate box under line 1.
Prepare a Form 982 for each exclusion if more than one applies. You'll also indicate the amount of debt being excluded from tax on line 2.
Check the box for line 1e, report the amount on line 2, and report the same amount on line 10b if you kept your house and restructured your mortgage for a lower mortgage balance. You can also reduce your cost basis in the house by the same amount as on line 10b.
You'll also have to make adjustments to other tax figures for the insolvency and bankruptcy exclusions. See the section on the reduction of tax attributes in IRS Publication 908 for details.
Legal Information Institute. "26 U.S. Code § 61. Gross Income Defined." Accessed Feb. 10, 2020.
Congress.gov. "H.R.3648 - Mortgage Forgiveness Debt Relief Act of 2007." Accessed Feb. 10, 2020.
Congress.gov. "H.R.1865 - Further Consolidated Appropriations Act, 2020." Accessed Feb. 10, 2020.
IRS. "Publication 908 (02/2019), Bankruptcy Tax Guide." Accessed Feb. 10, 2020.