Mortgage Forgiveness Tax Treatment

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Mortgage Forgiveness Tax Treatment

Portland attorney Robert Harris

By: Robert Harris
People considering a short sale or a deed in lieu of foreclosure or a strategic default need to consider how the IRS will treat the debt that is forgiven. Because the IRS typically treats debt that is forgiven as "income" A short sale particularly can result in the mortgage company sending the homeowner a 1099 form stating that the homeowner received "income". However, due to mortgage crisis, the federal government has passed legislative relief for most homeowners.

There is a great blog article from Hertsel Shadian, Attorney at Law, LLC, we found that succinctly sets out the tax issues encountered by all the homeowners that are considering a short sale, deed in lieu or strategic defaulting on their home.

If your mortgage debt is partly or entirely forgiven during tax years 2007 through 2012, you may be able to claim special tax relief and exclude the debt forgiven from your income. Here are 10 facts you should know about Mortgage Debt Forgiveness.

Normally, debt forgiveness results in taxable income. However, under the Mortgage Forgiveness Debt Relief Act of 2007, a taxpayer may be able to exclude up to $2 million of debt forgiven on his or her principal residence. The limit is $1 million for a married person filing a separate return.

A taxpayer may exclude debt reduced through mortgage restructuring, as well as mortgage debt forgiven in a foreclosure. To qualify, the debt must have been used to buy, build or substantially improve the taxpayer's principal residence and be secured by that residence.

Refinanced debt proceeds used for the purpose of substantially improving a taxpayer's principal residence also qualify for the exclusion.

Proceeds of refinanced debt used for other purposes - for example, to pay off credit card debt - do NOT qualify for the exclusion.

If a taxpayer qualifies, he or she can claim the special exclusion by filling out IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (see link below), and attach it to the taxpayer's federal income tax return for the tax year in which the qualified debt was forgiven.

Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the tax relief provision. In some cases, however, other tax relief provisions - such as insolvency - may be applicable. IRS Form 982 provides more details about these provisions.

If a taxpayer's debt is reduced or eliminated, the taxpayer normally will receive a year-end statement, Form 1099-C, Cancellation of Debt (see link below for a sample), from the lender. By law, this form must show the amount of debt forgiven and the fair market value of any property foreclosed.

Taxpayers should examine the Form 1099-C carefully. Taxpayers should notify the lender immediately if any of the information shown is incorrect. A taxpayer also should pay particular attention to the amount of debt forgiven in Box 2, as well as the value listed for his or her home in Box 7.

For additional information about the Mortgage Forgiveness Debt Relief Act of 2007, visit the official IRS website at Another good resource is IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments (see link below). Taxpayers also may obtain a copy of this publication and Form 982 by downloading them from the IRS website at or by calling 800-TAX-FORM (800-829-3676).

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