Debt Forgiveness for Mortgages

By Steven Roberts Updated on 8/2/2017

Many borrowers saw their homes foreclosed due to the loss of equity in their homes and inability to continue making mortgage payments. For these borrowers and others who were forced to restructure their mortgages, the Mortgage Forgiveness Debt Relief Act of 2007 provides some tax relief for borrowers. 

The Mortgage Forgiveness Debt Relief Act of 2007 was originally set to expire at the end of 2012 but was later extended through 2013.

Advantages of mortgage debt relief

• Exclude a maximum of $2 million of forgiven mortgage debt or canceled debt on a primary residence.
• Borrowers that have undergone either mortgage restructuring or foreclosure may qualify.
• Deadline extended through 2013.
• Borrowers can claim this tax relief with the IRS Form 982 (PDF).

Canceled debt is considered income

If a lender chooses to cancel or forgive your debt, this unpaid debt will be considered as income. As a result, this canceled or forgiven debt will be taxed by the government unless any exceptions apply.

Lenders typically report debt forgiveness using Form 1099-C, Cancellation of Debt. Individuals should record this forgiven debt on Form 1040, listed on Line 21 as additional income.

Tax codes include several exceptions to this standard management of forgiven debt. In general, the most beneficial for the debtor is the treatment of this forgiven debt as tax-free.

Tax relief for mortgage restructures and foreclosures

Under the Mortgage Forgiveness Debt Relief Act, borrowers who underwent foreclosure do not have to pay taxes on the amount of debt that was forgiven or canceled. This rule similarly applies for borrowers who were forced to adjust their mortgages to a lower principal balance.

As mentioned above, this tax exemption applies for up to $2 million in canceled mortgage debt, with up to $1 million for married couples filing separate returns. As a prerequisite, the home must be the borrower’s primary residence. Additionally, the debt must be related to the purchase, construction, or renovation of the home to qualify for tax exemption.

Ineligible Mortgage Debt

Not all mortgage debt will qualify for this tax benefit and consequently be excluded from being considered taxable income. For instance, home equity loans, through which borrowers can receive funds to be applied toward any purpose, may not be eligible, depending on how the money was spent. In addition, mortgage loans acquired for the purchase of either second homes or rental properties will not be considered.

The IRS describes the tax break eligibilty as such: “Taxpayers can exclude up to $2 million of debt forgiven on their principal residence. The limit is $1 million for a married person filing a separate return. This provision applies to debt forgiven in 2007, 2008 or 2009. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure qualify for this relief.”

Additional Exclusions for Canceled Debts

Besides the aforementioned requirement that the mortgage be on a primary residence, the tax code offers several other methods for ensuring that canceled debt is treated as tax-free. For example, other tax exempt debts include those under circumstances with debt canceled through bankruptcy proceedings, if the borrower is insolvent, or if the debt was regarded as a gift. Additionally, certain businesses and farm properties may be eligible for tax exemption, depending on the situation.

Exemption for Insolvency

When qualifying for tax exemption on canceled debts, insolvency may be particularly relevant to many borrowers with home equity loans, mortgages on second homes, and mortgages on rental properties. For those who do not meet the standard requirements for tax exemption, canceled debt of insolvent borrowers will be not be taxed. By definition, insolvency is a state in which a borrower’s liabilities or debts exceed the fair market worth of their total assets, and this may be particularly relevant to borrowers with properties that have sharply declined in value who may have been forced to restructure their loans or undergo foreclosure.