Mortgage Forgiveness and Debt Cancellation

The economy has hit taxpayers pretty hard over the last few years and many have had to negotiate with lenders to reduce their debts. In many cases, these lenders have allowed taxpayers to settle their debt for much less than what was owed. However, any cancelled debt over $600 may create a tax bill to the taxpayers. This includes mortgage forgiveness in the case of foreclosure or short sale.

Generally any time you have a foreclosure or a cancelled debt you are hit with a second hardship - a tax bill. Lenders who have forgiven a debt issue a Form 1099-C, Cancellation of Debt, which shows both the taxpayer and the IRS the amount that was forgiven. The IRS considers this to be taxable "other" income since that amount is money the taxpayer received but is no longer required to pay back to the lender. But in 2007, the Mortgage Debt Relief Act was passed to help homeowners avoid the double-edged sword of losing their house and having to pay taxes on the forgiven debt amount. The Act is in effect for mortgage debts cancelled from 2007 through 2012.

How Does the Mortgage Forgiveness Debt Act Protect Me?

The Mortgage Forgiveness Debt Act allows taxpayers to exclude from their taxes certain cancelled debts on their principle residence. The debt must be secured by their home and can apply to a first mortgage, funds secured to substantially improve the residence or a refinance. This includes debts reduced through mortgage restructuring or forgiven due to foreclosure.

The maximum amount of debt that qualifies for this exclusion is $2 million or $1 million if married filing separately. You will still have to pay taxes on any amount forgiven over this limit. Additionally, the Act does not allow you to exclude cancelled debt from a second home, credit cards or car loans.

How Do I Exclude Cancelled Debt From My Taxes?

Any forgiven mortgage debt will still need to be reported on your taxes. You will receive a Form 1099-C which will tell you the amount of debt that was cancelled. You must then fill out IRS Form 982 with your taxes. If you are only using this form to report your cancelled debt (it is used for other purposes as well) you will only need to fill out a portion of the form. Whether you kept ownership of your home will determine how many sections of the form you will need to complete. Using an online tax preparation site will help you fill out the appropriate sections and will automatically submit the correct forms with your return.

What Can I Do if My Cancelled Debt Doesn't Qualify Under the Act?

There are other exceptions that allow cancellation of debt to be non-taxable. In addition to mortgage forgiveness, other reasons include:

• Bankruptcy. Debt forgiven through bankruptcy is not taxable as income.
• Insolvency. If you are insolvent, meaning the total of your debts before the cancellation is more than the fair market value of your assets. You may only exclude the amount of your cancelled debt that does not exceed the amount of this difference. So, if your assets are worth $25,000 and your debt totals $35,000 the difference is $10,000. If a lender forgives $15,000 of debt, $10,000 will be excluded and $5,000 will be taxable.
• Non-recourse loans. If the loan is secured by personal property and the only recourse for default of the loan is repossession of that property, the lender cannot pursue you personally for the defaulted amount.

Again, for any amount of debt that's been cancelled or forgiven, you will receive a Form 1099-C from the lender. You must apply these rules against the debt to see if it qualifies to be excluded under the Mortgage Forgiveness Debt Relief Act.