Per the IRS, if you owe a debt to somone else and they cancel or forgive your debt, the cancelled amount may be taxable.
The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as, debt forgiven, in connection with a foreclosure, qualifies for the relief.
This provision applies to debt forgiven in calender years 2007 – 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). This exclusion does not apply if the discharge is due to services performed by the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.
Disclaimer: This article is adapted from IRS.gov. We do not own this information. It is made available freely to the public. It is recommended that you consult a tax attorney or tax accountant for tax advice.
The following are the most frequently asked questions and answers about the Mortgage Forgiveness Debt Relief Act and debt cancellation:
What is cancellation of debt?
If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.
Here’s a very simplified example: You borrow $100,000 and default on the loan after paying back $20,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $80,000, which is generally taxable income to you.
Is cancellation of debt income always taxable?
Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable income involve:
- Qualified principal residence: This is an exception created by the Mortgage Forgiveness Debt Relief Act of 2007 and applies to most homeowners.
- Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
- Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable income to you. You are insolvent when your total debts are more than the fair market value of your total assets.
- Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was farming, and the loan owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.
- Non-recourse loans: A non-recourse loan is a loan for which the lenders only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.
These exceptions are discussed in detail in Publication 4681.
What is the Mortgage Forgiveness Debt Relief Act of 2007?
The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on Dec. 20, 2007 (see news release IR-2008-17). Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence.
What does exclusion of income mean?
Normally, debt that is forgiven or cancelled by a lender must be included as income on your tax return and is taxable. But the Mortgage Forgiveness Debt Relief Act allows you to exclude certain cancelled debt on your principal residence from income. Debt reduced through mortgage restructuring, as well as, mortgage debt forgiven in connection with a foreclosure, qualifies for relief.
Does the Mortgage Forgiveness Debt Relief Act apply to all debt incurred to refinance a home?
Debt used to refinance your home qualifies for this exclusion, but only to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified. For more information, including an example, see Publication 4681.
How long is this special relief in effect?
It applies to qualified principal residence indebtedness forgiven in calendar years 2007- 2012.
Is there a limit on the amount of forgiven qualified principal residence indebtedness that can be excluded from income?
There is no dollar amount if the principal balance of the loan was less than $2 million ($1 million if married filing separately for the tax year) at the time the loan was forgiven. If the balance was greater, see the instructions to Form 982 and the detailed example in Publication 4681.
If the forgiven debt is excluded from income, do I have to report it on my tax return?
Yes. The amount of debt forgiven must be reported on Form 982 and this form must be attached to your tax return.
Do I have to complete the entire Form 982?
No. Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Adjustment), is used for other purposes in addition to reporting the exclusion of forgiveness of qualified principal residence indebtedness. If you are using the form only to report the exclusion of forgiveness of qualified principal residence indebtedness as the result of foreclosure on your principal residence, you only need to complete lines 1e and 2. If you kept ownership of your home and modification of the terms of your mortgage resulted in the forgiveness of qualified principal residence indebtedness, complete lines 1e, 2, and 10b. Attach Form 982 to your tax return.
Where can I get this form?
You can download and save the form to your computer, use your tax-preparation software, or use your tax accountant.
How do I know out how much debt was forgiven?
Your lender should send a Form 1099-C, Cancellation of Debt, by February 2, 2009. The amount of debt forgiven or cancelled will be shown in box 2. If this debt is all qualified principal residence indebtedness, the amount shown in box 2 will generally be the amount that you enter on lines 2 and 10b, if applicable, on Form 982.
Can I exclude debt forgiven on my second home?
Not under this provision. Only cancelled debt used to buy, build, or improve your principal residence or refinance debt incurred for those purposes qualifies for this exclusion. See Publication 4681 for further details.
If part of the forgiven debt doesn’t qualify for exclusion from income under this provision, is it possible that it may qualify for exclusion under a different provision?
Yes. The forgiven debt may qualify under the insolvency exclusion. Normally, you are not actually required to include the forgiven debts in income to the extent that you are insolvent. You are insolvent when your total liabilties exceed your total assets. The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness. If you believe you qualify for any of these exceptions, see the instructions for Form 982. Publication 4681 discusses each of these exceptions and includes examples.
I lost money on the foreclosure of my home. Can I claim a loss on my tax return?
No. Losses from sale or foreclosure of personal property are not deductible.
If I sold my home at a loss and the remaining loan is forgiven, does this constitute a cancellation of debt?
Yes. To the extent that a loan from a lender is not fully satisfied and a lender cancels the unsatisfied debt, you have cancellation of indebtedness income. If the amount forgiven or canceled is $600 or more, the lender must generally issue Form 1099-C, Cancellation of Debt, showing the amount of debt canceled. However, you may be able to exclude part or all of this income if the debt was qualified principal residence indebtedness, you were insolvent immediately before the discharge, or if the debt was cancelled in a Title 11 bankruptcy case. An exclusion is also available for the cancellation of certain non-business debts of a qualified individual as a result of a disaster in a Midwestern disaster area. See Form 982 for details.
If the remaining balance owed on my mortgage loan that I was personally liable for was cancelled after my foreclosure, may I still exclude the cancelled debt from income under the qualified principal residence exclusion, even though I no longer own my residence?
Yes, as long as the cancelled debt was qualified principal residence indebtedness. See Example 2 on page 13 of Publication 4681, Canceled Debts, Foreclosures, Repossession, and Abandonments.
Will I receive notification of cancellation of debt from my lender?
Yes. Lenders are required to send Form 1099-C, Cancellation of Debt, when they cancel any debt of $600 or more. The amount cancelled will be in box 2 of the form.
What if I disagree with the amount in box 2?
Contact your lender to work out any discrepancies and have the lender issue a corrected Form 1099-C.
How do I report the forgiveness of debt that is excluded from gross income?
- Check the appropriate box under line 1 on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082, Basis Adjustment) to indicate the type of discharge of indebtedness and enter the amount of the discharged debt excluded from gross income on line 2. Any remaining cancelled debt must be included as income on your tax return.
- File Form 982 with your tax return.
How do I know if I was insolvent?
You are insolvent when you total debts exceed the fair market value of all your assets. Assets include everything you own (e.g. car, house, condo, furniture, life insurance policies, stocks and other investments, pension or other retirement accounts).
How should I report the information and items needed to prove insolvency?
Use Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082, Basis Adjustment) to exclude cancelled debt from income to the extent you were insolvent immediately before cancellation. You were insolvent to the extent that your total liabilities exceeded the fair market value of your assets immediately before the cancellation.
To claim this exclusion, you must attach Form 982 to your income tax return. Check box 1b on Form 982, and, on line 2, include the smaller of the amount of the debt cancelled or the amount by which you were insolvent immediately prior to the cancellation. You must also reduce your tax attributes in Part II of Form 982.
Are there any publications I can read for more information?