Tax Relief for Cancellation of Mortgage Debt

Measure helps taxpayers in foreclosure

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One of the last measures passed by Congress in 2007 was the Mortgage Forgiveness Debt Relief Act of 2007. The main purpose from this law was to protect people from having to pay tax when mortgage debt is discharged, something that happens often in a mortgage foreclosure.

It may seem strange that this would even be an issue. Why hit someone with tax when they lost their home? The answer has to do with something called cancellation of debt income, or COD for short.

When you take out a loan you acquire money from the lender, but you don't report any income because you have an obligation to repay the loan. If the lender cancels the debt before you pay off the loan, though, you've been enriched by having received money you're no longer obligated to repay. That's the theory, anyway.

When a lender forecloses on a mortgage, proceeds from selling the property may not be enough to pay off the loan. Cancellation of the remaining debt will be reported to the IRS as COD income. Previously existing rules provide some exceptions: you don't pay tax when debt is cancelled in bankruptcy, for example, or when your net worth remains zero or negative even after the debt cancellation. But homeowners can end up in foreclosure without being able to qualify for these exceptions. Having to pay additional tax in this situation adds insult to injury.

Who's affected

The new law provides relief to taxpayers who meet certain requirements.

• The discharge of indebtedness has to occur on or after January 1, 2007. People that had debt cancelled in foreclosure before 2007 must rely on other exceptions or, if they don't qualify, pay the tax.
• The discharge has to occur before January 1, 2013. Originally this provision was set to expire after 2009, but it has been extended through 2012.
• The debt has to be secured by the home, and it must have been incurred in the acquisition, construction or substantial improvement of the home, or to refinance such debt, up to the principal amount outstanding at the time of the refinancing. If you took out a home equity loan for a purpose other than home improvement, this relief isn't available.
• The home has to be your principal residence. Relief isn't available if the loan was used to buy a property for rental or investment, or a second home.
• The benefit is limited to the first $2,000,000 of debt on the home ($1,000,000 if married filing separately).
• Relief isn't available if debt was discharged in exchange for services you provided to the lender or for any other reason unrelated to a decline in the value of the property or your financial condition.

If you have both qualified and unqualified debt, the benefit applies only to the extent that the amount of debt forgiveness exceeds the amount of nonqualified debt.

Basis reduction. If you qualify for this relief, the amount excluded from income will reduce your basis in the home. This won't matter except in a situation where you continue to own the home after the debt forgiveness, or you ended up with an overall profit after the foreclosure sale. Even then, you may avoid tax because of a rule allowing people that meet certain requirements to exclude up to $250,000 of gain from the sale of a principal residence. But if you don't qualify for the $250,000 exclusion, or your gain exceeds the amount you can exclude, this basis adjustment can result in additional tax. The additional tax is likely to be smaller than if you had to report COD income, however.

Claiming the benefit

The IRS has issued a revised version of Form 982, which can be used to report the exclusion of this item of income (see line 1e).