Taxation of Cancelation of Debt on a Second Home

Normally when a debt that you owe is forgiven, the amount of the debt that is canceled or forgiven may be taxable income to you. When your principal residence is involved, there is relief through the Mortgage Debt Relief Act of 2007. Under this law, which is in effect through 2012, if the debt on your principal residence is reduced through mortgage restructuring, or the mortgage debt is forgiven in a foreclosure, you can exclude up to $2 million ($1 million if married filing separately) of the debt cancellation or forgiveness from your taxable income.

The Mortgage Debt Relief Act applies to a homeowner's principal residence but not to a second home. According to the IRS, the foreclosure or abandonment of a home is considered a disposition. How you determine your gain or loss on the disposition depends on whether you were personally liable for repaying the debt, as opposed to a non-recourse loan in which case the property itself secures the loan and the creditor cannot pursue you personally for payment of the loan from your other assets.

If you were not personally liable for the debt, the full amount of the debt canceled by the foreclosure would be used in determining your gain or loss. If you are personally liable, the amount of the canceled debt up to the fair market value of the home is used to determine the gain or loss. But if you are personally liable, you may also have ordinary income on the foreclosure, subject to tax at the regular rates. If the canceled debt is more than the fair market value of the home, the excess would be ordinary income.

For a non-recourse loan in which the lender's only remedy is to foreclose and take possession of the home, the forgiveness of the mortgage loan would not result in ordinary income.

Your gain or loss on the sale, if you are not personally liable for the debt would therefore be the total amount of the canceled debt, minus your adjusted basis in the property. Your adjusted basis would generally be the cost of the property plus any improvements or additions, minus any casualty losses and any depreciation you claimed if you rented out the home or used it for business purposes. If you are personally liable for the debt, your gain or loss would be the canceled debt up to the fair market value of the home minus your adjusted basis.

For example, in the case of a foreclosure on your second home that has a market value of $150,000, for which you have a mortgage balance of $190,000 and you bought the home for $200,000, if you are personally liable for the debt you would have ordinary income of $40,000 for the debt cancellation ($190,000 of debt cancellation minus the fair market value of $150,000). You would have a loss on the foreclosure of $50,000 (the canceled debt up to the fair market value of $150,000 minus your basis of $200,000). If the second home was a personal residence, the loss would not be tax deductible.

If there is a foreclosure on your home, you should receive Form 1099-A, Acquisition or Abandonment of Secured Property, or Form 1099-C, Cancellation of Debt, from the lender.

There are some exceptions to reporting canceled debt as taxable income. Debts that are discharged through bankruptcy are not considered taxable income. And if you are insolvent; that is, your total debts are more than the fair market value of your total assets, some or all of the canceled debt may not be taxable. In this case you would have to file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) to report the exclusion.

Sources:
Form 982 - Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment)
Form 1099-A - Acquisition or Abandonment of Secured Property
Form 1099-C - Cancellation of Debt
The Mortgage Forgiveness Debt Relief Act and Debt Cancellation - IRS
Publication 523 - Selling Your Home - IRS
Publication 544 - Sales and Other Dispositions of Assets - IRS