A loan modification can be simply defined as a modification or change in your current mortgage contract with your current lender. These changes are usually only done when there is a risk of foreclosure, in which the lender makes the modification as a form of loss mitigation to prevent more losses on the loan.
A typical loan modification is normally in the form of an interest rate reduction, and/or late fees tacked on to the borrowers mortgage balance. Some lenders may also agree to what is called a “mortgage principle reduction.”
The definition of a mortgage principle reduction, is when the lender agrees to forgive part of the mortgage balance owed, in order for the borrower to afford the loan payments. For example, the homeowner may currently owe $300,000, and the lender agrees to forgive $100,000 which would bring the mortgage balance down to $200,000.
The main question people have is; “What happens to the $100,000 that was forgiven, and is this considered taxable income?”
According to IRS Publication 4681, loan modifications that involve principal balance reductions of a recourse loan generally result in taxable cancellation of indebtedness income. Page four of the publication states the following with regard to discounts and loan modifications:
If a lender discounts (reduces) the principal balance of a loan because you pay it off early, or agrees to a loan modification (a “workout”) that includes a reduction in the principal balance of a loan, the amount of the discount or the amount of principal reduction is canceled debt. However, if the debt is nonrecourse and you did not retain the collateral, you do not have cancellation of the debt income. The amount of the canceled debt must be included in income unless it meets one of the exceptions or exclusions.