Cancellation of Mortgage Debt and Your Tax Return

Linda Goold, Tax Counsel for the National Association of REALTORS® recently wrote an article for RISMedia’s Real Estate magazine advising consumers how to handle cancellation of mortgage debt on their tax returns. She offered some great information that is worthy of sharing.

According to Goold, in today’s market, a lender will sometimes forgive some portion of a borrower's debt. The general tax rule that applies to any debt forgiveness is that the amount forgiven is treated as taxable income to the borrower. Some exceptions to this rule exist and a law enacted in December 2007 provides relief to troubled borrowers when some portion of mortgage debt is forgiven. However, this relief expires on December 31, 2012. Goold provides the following general information you need to know about this law and cancellation of mortgage debt. Be sure to review this information with your accountant or personal tax advisor before filing this year’s tax return:

General Rule for Debt Forgiveness: If a lender forgives some or all of an individual’s debts, the general rule is that the forgiven amount is treated as ordinary income and the borrower must pay tax on the forgiven amount. Exceptions apply for bankruptcy, insolvency and certain other situations, including mortgage debt.

Current Law for Mortgage Debt (Jan. 1, 2007 through Dec. 31, 2012): A borrower can be excused from paying tax on forgiven mortgage debt. The debt must be secured by a principal residence and the total amount of the outstanding obligation may not exceed the original mortgage amount plus the cost of any improvements. The objective of the legislation was to assure fairness: Homeowners should not be required to pay income tax where there is no cash realized in a transaction.

Does the relief apply only to a sale? No. The provision has broader application. Lenders might forgive some portion of mortgage debt in a sale known as a short sale or in a foreclosure where the debt is wiped out. In addition, if a borrower still living in the home is able to make an arrangement with a lender that reduces the principal balance of a mortgage, the amount forgiven in that workout will not be taxed.

Can the homeowners in a short sale or foreclosure claim a loss? No. The loss is considered a personal loss and is therefore ineligible for either capital loss or ordinary loss treatment.

What happens to the seller when mortgage debt is forgiven? Until January 1, 2013, the homeowner will pay no tax on any forgiven amount. Under pre-2007 law, the amount of forgiven mortgage debt, would have been treated as income, and taxed at ordinary income rates.

Does this provision apply to a refinanced mortgage? Only in limited circumstances. The relief provision can apply to either an original or a refinanced mortgage. If the mortgage has been refinanced at any time, the relief is available only up to the amount of the original debt (plus the cost of any improvements). Thus, if the original mortgage was $125,000 and later refinanced in a cash-out arrangement for a debt totaling $140,000, the $15,000 cash-out is not eligible for relief if a lender later forgives some amount related to the cash-out. Tax relief is generally not available for second mortgages or home-equity lines of credit where the funds are not used for home improvement. Any amount that is not eligible for the relief provision will be taxed as ordinary income.

How does the homeowner get the correct information to the IRS? The lender is required to provide the homeowner and the IRS with a Form 1099 reflecting the amount of the forgiven debt. The borrower/homeowner must file a Form 982 to reflect the amount forgiven and to show the reason why the forgiven amount is not taxable. Any taxable portion of forgiven debt will then be reported on the homeowner’s Form 1040 for the tax year in which the debt was forgiven.

What if a property declines in value, but the owner stays in the house? The provision would not apply. The provision applies only at the time of sale or other disposition or when there is a workout (reduction of existing debt) with the lender. No mechanism exists to reflect a loss of value while the property is still being used as a residence.

Do all lenders forgive mortgage debt when property values decline or you are in foreclosure? No. Some states have laws that allow a lender to require a repayment arrangement, particularly if the borrower has other assets. Forgiveness of debt is always at the lender's discretion.

As a Member of the Top 5 in Real Estate Network®, I have a wealth of real estate and homeownership information that may be of help to you. Feel free to contact me any time to learn more about this important information, and be sure to forward this article on to any friends or family that may be interested as well.