Tax Treatment of Canceled Mortgage Debt

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Mortgage lenders sometimes cancel or forgive a person's debt. While this relieves the debtor of immediate financial stress, it often triggers a tax liability. Under the tax law, canceled debt is considered income to the debtor and is included as part of the debtor's income.

The lender reports this canceled debt both to the individual and to the Internal Revenue Service using Form 1099-C. The tax law provides three remedies for excluding canceled debts from taxes. There's an exclusion in the case of insolvency, for cases involving bankruptcy, and a new exclusion for certain types of mortgage debt. The mortgage exclusion is particularly important for people who are going through foreclosure, short sale or having some of their principal reduced through a loan modification.

In December 2007, Congress passed the Mortgage Forgiveness Debt Relief Act. This law provides tax relief for homeowners who lose their house through foreclosure or short sales, or who restructure their mortgages with a lower principal amount. The law enables individuals to exclude from tax up to $2 million of certain mortgage debt canceled by lenders.

There are a number of criteria that need to be met to qualify for this exclusion. Canceled mortgage debt that does not meet these criteria might still be excluded using the rules for insolvency or bankruptcy. People with home equity loans and cash-out or debt-consolidation refinance will need to do some extra bookkeeping to make sure they can take full advantage of all the tax exclusions that apply to them.

Canceled Debt and Taxable Income

Normally, debt that is forgiven or canceled by a lender is considered taxable income to the debtor. The tax laws specify that canceled debts are included in a person's income and subject to taxes. For reference, the law is Internal Revenue Code Section 61(a)(12). This law says that "income from discharge of indebtedness" is included in a person's gross income for the year.

The tax laws also spell out specific circumstances when a person will not have to pay tax on canceled debts. These are called exclusions, which means the amount will not be included in a person's taxable income.

There are several exclusions available, but only three of them apply to the situation of canceled mortgages. These three exclusions are for:

  • Debt canceled in a bankruptcy proceeding
  • Debt canceled when the person is insolvent
  • Debt that qualifies under the Mortgage Forgiveness Debt Relief Act

Each of these exclusions has their own set of criteria and reporting procedures. For people who have lost their homes, it may be crucial to gather original loan documents to show where the loan money was spent.

For further reference on canceled debt in general, see the Debt Cancellation section of Publication 908 and the Canceled Debts section of Publication 17.

Qualifying Under the Mortgage Forgiveness Debt Relief Act

Mortgage debt may qualify to be excluded from income under the Mortgage Forgiveness Debt Relief Act. This law provides that certain types of canceled mortgage debt can be excluded from taxes. This exclusion is important for people whose homes have been foreclosed, or who sold their house short, or who restructured their mortgage.

There are two types of mortgage debt in the tax code: acquisition debt and home equity debt. The distinction between the two impacts which exclusion may apply. Acquisition debt is debt whose proceeds were used to buy, build, or substantially improve a principal residence. Home equity debt is debt whose proceeds were not used to buy, build, or improve the residence.

Acquisition debt can be excluded from tax under the Mortgage Forgiveness Debt Relief Act. Home equity debt cannot be excluded under this new law. Instead, home equity debt may qualify under the insolvency or bankruptcy exclusions.

There is one further criterion as well. The house must have been used as the main home, which means it was the principal place of residence for the debtor. That means second homes, vacation homes, investment properties, or rental units will not qualify under this exclusion. Canceled debts for those properties may qualify, however, under the insolvency or bankruptcy exclusions.

How much debt can be excluded from tax? Canceled mortgage debt of up to $2 million (or $1 million is married and filing a separate return) can be excluded from income for the years 2007 through 2016. After 2016, people can still exclude the debt forgiveness from their taxes as long as the debtor and the lender entered a binding written agreement to cancel the debt no later than December 31, 2016.

Separating Acquisition Debt and Home Equity Debt

Before you can determine how a canceled mortgage will be handled for tax purposes, you will first need to know how much of your canceled debt falls into the two categories:

  • Acquisition debt 
  • Home equity debt 

Separating out these two kinds of mortgage debt could be easy or complicated. How complicated the process will be depends on whether you refinanced your mortgages. 

If your only loans were the original mortgages used to buy your house, then all of your debt will be acquisition debt. You can exclude up to $2 million in acquisition debt under the Mortgage Forgiveness Debt Relief Act (or $1 million for a married person filing a separate return).

For refinanced loans, only the outstanding balance on the original acquisition debt mortgages will count. If you did a debt consolidation refinance, or took cash out, or had a home equity line of credit used for purposes other than to acquire a house, then that part of your debt will be home equity debt. This home equity debt will not qualify as part of the $2 million exclusion but may qualify for exclusion under the insolvency or bankruptcy exceptions.

You will need to 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 percent of home price)
$40,000 (second for 20 percent 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

Insolvency Exclusion for Canceled Debts

Home equity debt (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 the insolvency exclusion. Insolvency happens when the debt liabilities exceed the fair market value of a person's assets. This will be the case with many people who have lost their home since the market value of the home fell beneath the amount they owed on the property.

The IRS explains the insolvency exclusion:

"A debtor is insolvent when, and to the extent, the debtor's liabilities exceed the FMV [fair market value] of the assets. Determine the debtor's liabilities and the FMV of the assets immediately before the cancellation of the debtor's debt to determine whether or not the debtor is insolvent and the amount by which the debtor is insolvent.
"Exclude from the debtor's gross income debt canceled when the debtor is insolvent, but only up to the amount by which the debtor is insolvent. However, you must use the amount excluded to reduce certain tax attributes" (Publication 908).

The insolvency exclusion amount is the amount of canceled debt that exceeds the fair market value of your assets. Let's say a taxpayer owns a house with a fair market value of $150,000 with an outstanding mortgage balance of $235,000, the person has no other assets, and 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), and this amount could be excluded under the insolvency provision. The remaining $50,000 of debt would qualify for the mortgage exclusion. (Adapted from the example given in the Instructions for Form 982, page 4, ordering rule.)

Bankruptcy Exclusion for Canceled Debts

Canceled debts can be excluded from taxable income if the debts are forgiven as part of a bankruptcy proceeding.

To qualify for the tax-free treatment, the taxpayer will need to have filed for bankruptcy and the debts canceled at the order of the bankruptcy court. For taxpayers faced with foreclosure or short-sales, 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.

Filing for bankruptcy can generate several tax implications, so for more details see the Publication 908, Bankruptcy Tax Guide on the IRS Web site.

Reporting Canceled Debts on the Tax Return

Debts canceled by a lender are reported on your tax return. How it's reported depends on whether you qualify for any of the exclusions.

A lender will submit Form 1099-C both to the IRS and to the person whose debt was canceled or forgiven. The document reports the amount of canceled debt. The amount of canceled debt is shown in box 2 of the form. For people who gave up their home in a short sale, foreclosure, or another settlement process, the amount shown is for the loan principal that was left unpaid after the settlement. A description of the debt is shown in Box 5, such as the address of the property that the loan was for. Box 7 of the form will report 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.

Follow these steps to report canceled debt on your tax return:

  1. Report any canceled debts that are not excluded on Form 1040 Line 21.
  2. 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, then you will need to fill out Form 982 (pdf, 5 pages including instructions).
  3. On Form 982, indicate which exclusion applies to you by checking the appropriate box on line 1. If more than more exclusion applies, then prepare a Form 982 for each exclusion. You'll also indicate the amount of debt being excluded from tax on line 2.
  4. For the insolvency and bankruptcy exclusions, you will also need to make adjustments to other tax figures. For details, see the section on the reduction of tax attributes in Publication 908.
  5. If you kept your house and restructured your mortgage for a lower mortgage balance, you will need to check the box for line 1e, report the amount on line 2, and report the same amount on line 10b. You also reduce your cost basis in the house by the same amount as on line 10b.


The Internal Revenue Service offers additional information on canceled debts and the Mortgage Forgiveness Debt Relief Act: