My Lender Forgave My Mortgage Debt. Now what?

You have a home mortgage, and were unlucky enough to buy high.  In the real estate crash, your home value sunk below the mortgage amount.  You were "underwater".  You could not sell the home because you would have had to come to the closing table with a large amount necessary to pay off the mortgage.  This is the situation when a "short sale" is used.  The lender agrees to accept less for its loan than what you owe, in order to cut its losses and get something out of the property.  So you sell the property.  You walk away.  The lender agrees not to chase you for the balance that you owe on the mortgage loan.  Are you done?  

Not quite.  Under federal tax law, when your creditor forgives a debt that you owe to him, the government considers that forgiveness as income to you, and you are taxed on it.  If today you owe someone $100,000 for a mortgage loan; and tomorrow that lender agrees that you don't have to pay it, then you are $100,000 richer.  And the government wants its cut.  

But the economic crisis that we have been through has given birth to legislation that changes that rule if the debt that is forgiven is home mortgage debt.  Here's the explanation for what you need to do to benefit, straight from the horse's mouth - IRS Tax Tip 2014-31:

Special Exclusion for Cancelled Home Mortgage Debt

If a lender cancels or forgives money you owe, you usually have to pay tax on that amount. But when it comes to your home, an important exception to this rule may apply in 2013. Here are several key facts from the IRS about the special exclusion for cancelled home mortgage debt:

• If the cancelled debt was a mortgage loan on your main home, you may be able to exclude the cancelled amount from your income. To qualify you must have used the loan to buy, build or substantially improve your main home. The loan must also be secured by your main home.

• If your lender cancelled part of your mortgage through a loan modification, or ‘workout,’ you may be able to exclude that amount from your income. You may also be able to exclude debt discharged as part of the Home Affordable Modification Program. Visit IRS.gov for more details about HAMP. The exclusion may also apply to the amount of debt cancelled in a foreclosure.

• The exclusion may apply to amounts cancelled on a refinanced mortgage. This applies only if you used proceeds from the refinancing to buy, build or greatly improve your main home. Proceeds used for other purposes don’t qualify. For example, a loan that you used to pay your credit card debt doesn’t qualify.

• Other types of cancelled debt do not qualify for this special exclusion. This includes debt cancelled on second homes, rental and business property, credit card debt or car loans.

• If your lender reduced or cancelled at least $600 of your mortgage debt, you should receive Form 1099-C, Cancellation of Debt, in January of the following year. This form shows the amount of cancelled debt and other information. Notify your lender if any information on the form is wrong.

• Report the excluded debt on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. File the completed form with your federal tax return.

• Use IRS e-file to file your tax return. E-file is the easiest way to file because the software will do the hard work for you. You can use IRS Free File to prepare and e-file your tax return with either free, brand-name software or online fillable forms – all for free. Otherwise, you may file electronically with commercial software, or through a paid preparer.

• Whether you use IRS e-File or mail a paper return, you can use the Interactive Tax Assistant on IRS.gov to find out if you must pay tax on cancelled mortgage debt.  

For more on this topic, see Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments. You can get IRS forms and publications online at IRS.gov or by calling 800-TAX-FORM (800-829-3676).


Additional IRS Resources:

• Mortgage Forgiveness Debt Relief Act and Debt Cancellation