Your Mortgage Debt Was Forgiven, But Do You Owe Tax On That?

Some homeowners have been able to negotiate their way out of underwater mortgages and have emerged free and clear, due to short sales, foreclosures and other options that they may have had available for their situation.
Or have they?
If you managed to get out of a bad mortgage, you do need to confirm you don’t run afoul of the IRS by failing to pay any applicable tax on that loan forgiveness.
Cancellation of Debt
When a bank or other lender forgives a debt, some accounting must be considered. A loan does not qualify as income, because you have to repay the lender with interest, so that money “costs” you.
If the loan is forgiven, the amount “cancelled” can be counted as income, as you received money and did not pay it back. This seems particularly unfair in the context of underwater mortgages; given the property is no longer worth the original loan value, but the “gain” is based on the loan value.
The Mortgage Forgiveness Debt Relief Act
Congress recognized that for many people, if you are in a financial circumstance that necessitates a cancellation of debt, receiving a tax bill for the mortgage forgiveness, might not feel appropriate.
The Mortgage Debt Relief Act of 2007 to allows taxpayers to avoid liability for the “income” resulting from the discharge of debt on your principal residence.
To be eligible, the debt forgiveness must have occurred from 2007 through 2012.
The debt must be related to a “decline in the home’s value or the taxpayer’s financial condition.” $2 million may be forgiven ($1 million if married filing separately.)
Equity loan debt qualifies, but only if the proceeds were used for improvements to the home. If you used a $20,000 home equity loan for paying off credit card debt or buying a car, it cannot be excluded from your income tax.
When doing your taxes, you will now if you have potential debt forgiveness income if your received the IRS Form 1099-C, Cancellation of Debt from your lender.