CARL WATTS & ASSOCIATES

April 08, 2013



The Mortgage Forgiveness Debt Relief Act and Debt Cancellation enacted in 2007 was designed to provide tax relief for homeowners who had lost their properties to foreclosure or had restructured their mortgage by reducing the total amount of money owed.


Set to expire at the end of 2012, the Mortgage Debt Forgiveness Act became part of the Fiscal Cliff Deal and was extended throughout 2013.

Under ordinary circumstances, anytime a lender cancels or forgives debt, that is usually considered a taxable event. The IRS specifies that “if a debt you owe is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income.”



Therefore, homeowners were required to count canceled mortgage debt forgiven by a commercial lender as income on their tax return. This created a tax liability that few families having already lost their homes could afford, and threatened their future financial recovery prospects.



Homeowners who decreased mortgage payments with mortgage restructuring also had to report the difference between the original mortgage amount and the new mortgage amount as income.



The Mortgage Debt Forgiveness Act provides several exceptions to the tax treatment of forgiven debts.

Below are the exceptions that qualify for the taxable income exclusion.

For qualified principal residence indebtedness:



  • The mortgage debt forgiven must be on your principal residence. (Second homes or vacation homes are excluded);


  • You must have used the mortgage debt to purchase, build or renovate your home;

  • Mortgage debt from refinancing home construction, purchase and improvements also qualifies;

  • The maximum amount you can treat as qualified principal residence indebtedness is $2 million
    ($1 million if single) at the time the loan was forgiven.



The Mortgage Forgiveness Debt Relief Act applies to three types of sellers:


  1. Short sales (read our newsletter on the subject),

  2. Principal reduction - when a homeowner's monthly payment is reduced by the lender in order to prevent foreclosure, and

  3. Foreclosure - when the lender attempts to collect the balance of the loan by taking possession of the property and selling it.

There are a few more situations when cancellation of debt income is not taxable that must not be overlooked.


Bankruptcy

Debts discharged through bankruptcy are not considered taxable income.


Insolvency

If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. (You are insolvent when your total debts are more than the fair market value of your total assets.)


Certain farm debts

If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.

Non-recourse loans

A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default.

Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.

Cancellation of student loan may be excluded if your student loan was made by:

  • the federal government, or a state or local government or subdivision;

  • a tax-exempt public benefit corporation which has control of a state, county or municipal hospital where the employees are considered public employees; or

  • a school which has a program to encourage students to work in underserved occupations or areas, and has an agreement with one of the above to fund the program, under the direction of a governmental unit or a charitable or educational organization.

Nonbusiness credit card debt cancellation can be excluded from income if the cancellation occurred in a title 11 bankruptcy case, or to the extent you were insolvent just before the cancellation.

So, how do you report debt forgiveness to the IRS?

First of all, lenders are required to send Form 1099-C, Cancellation of Debt, when they cancel any debt of $600 or more. The amount cancelled will be in box 2 of the form. The IRS also receives a copy.

To claim the debt forgiveness exclusion you must attach Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) to your federal income tax return. 

Check the appropriate box under line 1 on Form 982 to indicate the type of discharge of indebtedness and enter the amount of the discharged debt excluded from gross income on line 2 of the form. 

Any remaining canceled debt must be included as income on your tax return.

To find out if any of these situations apply to you for your 2012 taxes, you should carefully read the IRS instructions or, even better, consult with a tax professional to make sure you take advantage of all tax relief available to your specific circumstances.


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office@carlwatts.com
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Mortgage and Cancelled
Debt Forgiveness
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