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March 27th, 2012

Your lender may forgive your mortgage debt, but will the IRS?

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Michele Lerner  2012 60x60The post below was written by HSH.com contributor Michele Lerner. Michele has contributed several features to HSH.com, including her most-recent work, “Conventional vs. FHA financing: Which is cheaper?” and “How to challenge that low appraisal.” This is Michele’s second blog post for HSH.com:

While you may not think of discharged mortgage debt as income since you don’t actually get to make a deposit in your bank account, the IRS considers canceled debt to be income.

For homeowners who have undergone a foreclosure or a short sale, the difference between your loan pay-off amount and what the bank actually got from the sale of your home is considered canceled debt. The same goes for a loan modification that reduced your principal balance. For example, if your loan balance was $250,000 and your short sale agreement netted $200,000 for your lender, $50,000 would be considered the canceled debt.

Mortgage Forgiveness Debt Relief Act of 2007

The Mortgage Forgiveness Debt Relief Act of 2007 protects consumers in some circumstances from paying taxes on the canceled mortgage debt. However, this act is set to expire at the end of 2012. The Obama administration has proposed extending the Act through 2014 as part of their recent budget proposal, but no decision has been made at this time to pass that budget.

If you think you are headed toward foreclosure, short sale or principal reduction, you may want to take steps to make sure the final settlement takes place before January 1, 2013.

How does a refinance in 2011 affect your taxes?

Raffi Tal, executive vice president of I Short Sale Inc. in Woodland Hills, Calif., says there are ways to avoid paying taxes on forgiven debt. “Ninety-eight percent of the clients I work with have not had to pay taxes on their forgiven debt after a short sale,” says Tal. “I always tell everyone to worry first about completing a short sale and avoiding foreclosure and then later on worry about the tax issues or let your tax accountant deal with it.”

Most homeowners qualify for tax relief

Tal says most homeowners will qualify for tax relief under the Mortgage Forgiveness Debt Relief Act, as long as their mortgage debt was forgiven between January 1, 2007 and December 31, 2012.

To qualify for the tax exclusion:

  • The forgiven debt must be on your principal residence, not a second home or an investment property
  • The forgiven debt can be on both a first and second mortgage as long as both mortgages were secured by your principal residence and the money you borrowed was used to buy, build or improve your home
  • The amount of debt forgiven must be greater than $600 and less than $2 million (or $1 million if married, filing separately)

IRS forms

If you have debt that’s been forgiven by a lender, you should receive IRS Form 1099C, “Cancellation of Debt,” in the mail from your lender. IRS Publication 4681 provides more detail on the exemption. You’ll need to complete Form 982 with the amount of debt forgiven, regardless of whether you qualify for an exemption.

Tal says that if you don’t qualify under the debt relief act, for instance, if your property is a second home or an investment property, you still may be allowed to avoid paying taxes on the forgiven debt.

“The IRS also has a Debt Relief Exemption that has been around for a long time which basically allows you to declare yourself insolvent,” says Tal. “The type of property you owned doesn’t matter in this case. All that matters is that on the day you file your taxes, your total liabilities must exceed your net assets.”

IRS Publications 544 and 908 provide more detailed information about avoiding taxes based on insolvency. You would need to complete Form 982 for this type of tax exemption, too.

If you have canceled mortgage in 2011 or 2012, you may want to consult a tax accountant who can give you individualized advice.

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One Response to “Your lender may forgive your mortgage debt, but will the IRS?”

  1. johnleonz Says: March 28th, 2012 at 1:10 am

    To find a great refinance rate, you should talk to at least one national mortgage lender, one local lender, a credit union and “Official Refinance”. Also ask your friends which bankers and brokers they have used.

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HSH.com's daily blog focuses on the latest developments in the mortgage and housing markets. Our mission is to relate how changes in mortgage rates and housing policy, as well as the latest financial news, impacts consumers, homebuyers and industry insiders alike. Our 30-plus years of experience in the mortgage industry gives us an edge as we break down the latest changes in an ever-changing market.

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Tim Manni is the Managing Editor of HSH.com and the author of their daily blog, which concentrates on the latest developments in the mortgage and housing markets.

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