Are you eligible for Mortgage Debt Forgiveness?

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)