You save tax
on mortgage repayments. But if the debt is cancelled, do you pay taxes on the
amount you have already received?
Normally, debt that is forgiven or cancelled by a lender
must be included as income on your tax return and is taxable.
Example: 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.
Mortgage
Debt Forgiveness Act of 2007 to the rescue!
Mortgage Forgiveness Debt Relief Act allows you to exclude
certain cancelled debt (up to $2 million) on your principal residence from
income. Debt reduced through mortgage restructuring, as well as mortgage debt
forgiven in connection with a foreclosure, qualifies for the relief. It
applies to debt forgiven in calendar years 2007 through 2012.
Example:
Isabella paid $200,000 for her home. She paid $15,000 down
and borrowed the remaining $185,000 from a bank.
Isabella is personally liable
for the loan and the house is pledged as security for the loan.
In 2011, the
bank foreclosed on the loan because Isabella stopped making payments.
When the
bank foreclosed the mortgage, the balance due was $180,000, the FMV of the
house was $170.000, and Isabella’s adjusted basis was $175,000 due to a casualty
loss she had deducted.
At the time of the foreclosure, the bank forgave $2,000
of the $10,000 debt in excess of the FMV ($180,000 minus $170,000).
Isabella
remained personally liable for the $8,000 balance.
In this case, Isabella has ordinary income from the
cancellation of debt in the amount of $2000.
The $2000 income from the cancellation
of debt is figured by subtracting the $170,000 FMV of the house form the
$172,000 difference between Isabella’s total outstanding debt immediately
before the transfer of property reduced by the amount for which she remains
personally liable immediately after the transfer ($180,000 minus $8000).
Isabella
is able to exclude $2000 of cancelled debt from her income under qualified
principal residence indebtedness rules.
Gain or Loss?
Isabella must determine her gain or loss from the
foreclosure. In this case, the amount that Isabella realizes is $170,000. This
is the smaller of
(a) the $180,000
outstanding debt immediately before the transfer reduced by the $8000 for which
she remains personal liable immediately after the transfer ($180,000-$8000 = $172,000)
or
(b) the $170,000 FMV of
the house.
Isabella figures her gain or loss on the foreclosure by
comparing $170,000 amount realized with her $175,000 adjusted basis. She has a
$5000 nondeductible loss.
How to claim it?
Collect form 1099-C from your lender, showing the amount of
debt and fair market value of any property foreclosed.
Fill form 982 attach to the federal income tax return for the
tax year in which the qualified debt was forgiven.
Refer IRS Publication 4681 Canceled, Debts, Foreclosures, Repossessions
and Abandonments (for Individuals)
