The U.S. Government has just announced that a Bill just passed that will allow for the extension of the Mortgage Debt Relief Act of 2007 for an additional two years of protection covering tax years 2015 and 2016. This tax relief applies to qualified borrowers when a lender cancels, forgives and or reduces the mortgage debt on their primary residence through various loss mitigation methods such as a loan modification, and debt forgiven in connection with a foreclosure or a short sale.
Normally when this happens, you may have to report the cancelled or forgiven amount as income to the IRS for tax purposes because your legal obligation to pay back your lender was forgiven. However under this law, many struggling homeowners will now be able to exclude income on their taxes from the discharge or reduction of their mortgage debt.
The law does not apply to debt forgiven on second homes, investment property, and business property. It also doesn’t cover debt forgiven on credit cards or car loans. The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition. According to the Internal Revenue Office (IRS), up to $2 million of forgiven debt only on your primary residence is eligible for this exclusion ($1 million if married filing separately).
Certain payments on the balance of a mortgage via a loan modification under the Home Affordable Modification Program (HAMP) may not be taxable. Other exclusions from paying taxes on this forgiven debt are debt canceled in a Title 11 bankruptcy or during insolvency, canceled qualified farm debt, and canceled qualified real property business debt.
The IRS gives tax payers the simple following example scenario; “You borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you.”
If the forgiven mortgage debt was reduced or cancelled at least $600, it is subject to taxation under the law, and you most likely will receive from your lender in the mail what is called a form 1099-C, Cancellation of Debt. This form shows the amount of canceled debt that you will have to file with your federal tax return using the 1099-C form which will be considered as part of your gross income.
Let me please warn you that sometimes lenders issue a 1099-C form when they shouldn’t, or they may not even send you a 1099-C when in fact you should have gotten one, either because they made a mistake, or because of incompetence. In the end, it is your responsibility under the law to properly file your taxes regardless of any mistakes made by your lender.
You also may be insolvent and not have to pay taxes.
The meaning of insolvency is when your current debts exceed the value of all your liquid assets such as money, property, stocks and bonds. For example, let’s say you have assets and cash worth $50,000 and you owe $200,000 on debts, under the federal law you are considered insolvent by $150,000.
Is your mortgage debt non-recourse?
The IRS Publication 4681 says: “Nonrecourse debt” applies to when you have owned a property that was subject to a nonrecourse debt in ex-cess of the FMV of the property, the lender’s foreclosure on the property does not result in ordinary income from the cancellation of debt.”
If you qualify, you can claim a special exclusion by filling out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attach it to your federal income tax return for the tax year in which the qualified debt was forgiven.
As you can see this can get a bit confusing, so it is important you get educated in order to properly file your taxes or to challenge an improperly issued 1099-C by your lender. The best thing to do if you had debt forgiveness is to get educated, and seek the advice of a competent accountant who understands these unique laws so that they can properly advise you in the filing of your taxes.
1. Main Home – If the cancelled debt was a loan on your main home, you may be able to exclude the cancelled amount from your income. You must have used the loan to buy, build or substantially improve your main home to qualify. Your main home must also secure the mortgage.
2. Loan Modification – If your lender cancelled part of your mortgage through a loan modification or ‘workout,’ you may be able to exclude that amount from your income. You may also be able to exclude debt discharged as part of the Home Affordable Modification Program, or HAMP. The exclusion may also apply to the amount of debt cancelled in a foreclosure.
3. Refinanced Mortgage – The exclusion may apply to amounts cancelled on a refinanced mortgage. This applies only if you used proceeds from the refinancing to buy, build or substantially improve your main home. Amounts used for other purposes don’t qualify.
4. Other Cancelled Debt – Other types of cancelled debt such as second homes, rental and business property, credit card debt or car loans do not qualify for this special exclusion. On the other hand, there are other rules that may allow those types of cancelled debts to be nontaxable.
5. Form 1099-C – If your lender reduced or cancelled at least $600 of your debt, you should receive Form 1099-C, Cancellation of Debt, in January of the next year. This form shows the amount of cancelled debt and other information.
7. IRS Free File – IRS e-file is fastest, safest, and easiest way to file. You can use IRS Free File to e-file your tax return for free. If you earned $60,000 or less, you can use brand name tax software. The software does the math and completes the right forms for you. If you earned more than $60,000, use Free File Fillable Forms. This option uses electronic versions of IRS paper forms. It is best for people who are used to doing their own taxes. Free File is available only on IRS.gov/freefile.
8. IRS.gov tool – The IRS has several free tools on its website to help you file your tax return. Use the Interactive Tax Assistant tool on IRS.gov to find out if your cancelled mortgage debt is taxable.
9. Exclusion extended – The law that authorized this exclusion had expired at the end of 2013. The Tax Increase Prevention Act extended it to apply for one year, through Dec. 31, 2016.
10. More Information – For more on this topic see Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments.
Additional IRS Resources and Links:
- See the federal law Mortgage Forgiveness Debt Relief Act and Debt Cancellation for more information
- You may obtain copies of IRS publications and forms either by downloading them from www.irs.gov or by calling 800-TAX-FORM (800-829-3676).
- Check Tax Topic 431 – “Canceled Debt – Is It Taxable or Not?” from the Tax Topic Index
- Home Foreclosure and Debt Cancellation