How Is Canceled Debt and Mortgage Forgiveness Taxed?

Renewed legislation offers relief in 2020 for taxes from a foreclosure

House in background with red "Foreclosure Bank Owned" sign in the foreground in front yard.
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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, which has been extended through the end of 2020. 

The act was first passed by Congress in December 2007 to provide tax relief for homeowners who had lost their properties. The law, which lapsed temporarily in 2018 and 2019, allowed individuals to exclude from tax certain mortgage debt that was canceled by lenders. Now that option is again available for this year, and it may become relevant for many homeowners amid record unemployment and an impending recession. 

History of Mortgage Forgiveness Act

Congress passed the Mortgage Forgiveness Debt Relief Act (MFDRA) in December 2007 to provide tax relief for homeowners who had 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. 

When Is a Mortgage Income?

Here’s an easy way to think about taxation of canceled or forgiven debt. 

Maybe you’re going through a tough time and your friend gives you $100. You promise to pay him back on your next payday, but he tells you not to worry about it. Bottom line: 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. 

The same applies when a lender gives you money to purchase a home, in other words, your mortgage. Should the bank foreclose and forgive what’s left of your loan, that money—the principal balance, although not any outstanding interest­—is deemed income to you under the tax code because you don’t have to pay it back.

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 income on your next tax return, with a few exceptions.

The mortgage debt relief law also spells out specific circumstances when a person will not have to pay tax on canceled debts. 

Exceptions to the Rule

These exceptions 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.

Discharges of indebtedness occurring after Dec. 31, 2017, through the end of 2020 all qualify for MFDRA relief, if they meet a number of criteria.

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 act

Limits on Discharged Debt

Canceled mortgage debt of up to $2 million—or $1 million if you're married and filing a separate return—can be excluded from income.

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’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.

Calculating Forgiven Indebtedness

All of your debt will be acquisition debt if your only loans were the original mortgages used to buy the 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 used for purposes other than to acquire a house. This debt will not qualify under the relief act.

Other Options

The newly revived tax relief, known as the Qualified Principal Residence Indebtedness Exclusion (QPRI), 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, although you have an either/or option with another exclusion.

  • The bankruptcy exclusion would apply if you filed for bankruptcy protection under any of the approaches available under Chapter 11 of the federal Bankruptcy Code. This includes Chapters 7 and 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 not 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 this exclusion. You might need the help of a tax professional to calculate this accurately, although the IRS does offer an insolvency worksheet in Publication 4681 to help you along. 

Reporting 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. CQ, IC
IRS.gov. "Form 982." Accessed April 2, 2020. You don’t have to include the amount that appears on Form 1099-C on your tax return, at least up to the limit.

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

The Bottom Line 

Being able to avoid taxation of canceled or forgiven mortgage debt could be a significant help if you’re forced into seeking relief or are foreclosed on by a lender. Ask your tax professional or mortgage bank if you qualify, and complete the IRS paperwork for the 2020 tax year, in case this form of the QPRI Exclusion is not renewed in the future. 

Article Sources

  1. Congress.gov. "H.R.3648 - Mortgage Forgiveness Debt Relief Act of 2007." Accessed April 8, 2020.

  2. IRS.gov. "Home Foreclosure and Debt Cancellation." Accessed April 8, 2020.

  3. IRS.gov. "Topic No. 431 Canceled Debt – Is It Taxable or Not?" Accessed April 8, 2020.

  4. National Consumer Law Center. "Qualified Principal Residence Indebtedness Exclusion Revived and Extended." Accessed April 8, 2020.

  5. IRS.gov. "Publication 4681 (2019), Canceled Debts, Foreclosures, Repossessions, and Abandonments." Accessed April 8, 2020.

  6. IRS.gov. "Form 982." Accessed April 8, 2020.