The Mortgage Forgiveness Debt Relief Act and Debt Cancellation

Very often we get asked by clients of the tax consequences of both Bankruptcy and Foreclosure. The below is a brief summary of the current law on the matters.

 

Normally, a debt that is forgiven or cancelled by a lender must be included as income on your tax return and is taxable.

With the introduction of the Mortgage Debt Relief Act of 2007, taxpayers are given tax relief for debt forgiven (up to $2 million and $1 million if married and filing separately) in the years 2007 to 2012. Taxpayers can qualify for relief under certain instances: debt discharged on primary residence, debt reduced through mortgage restructuring or debt forgiven in connection with a foreclosure. In addition, the debt must be secured by the home.



If the forgiven debt is excluded from your income, you are still required to complete a Form 982 and attach it to your tax return. You may find this form on the IRS website. The amount you enter onto the form is the amount your lender sends you on a Form 1099-C (in box 2), Cancellation of Debt. The Lender is required to send you a Form 1099-C any time they forgive a debt greater than $600. You complete the lines of the form based on what is applicable to your forgiven debt.

 

In cases of a refinance, the debt relief act can apply if and only if the principal balance of the first mortgage qualified under the act. If you sold your home at a loss and the lender cancels the remaining debt, you may also be eligible for relief if the loss qualifies as primary mortgage indebtedness under the Mortgage Debt Relief Act.

 

In cases of cancelled student loan debt, this debt will not be considered taxable income if you fulfilled any provision to work in a certain profession for a stated period of time. You can also qualify if your student loan was made by (a) the federal government, or a state or local government or subdivision; (b) a tax-exempt public benefit corporation which has control of a state, county or municipal hospital where the employees are considered public employees; or (c) 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 In other cases, cancelled student loan debt may lead to taxable income.

Of course, there are also exceptions to the relief act. If the discharge of debt is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition, the taxpayer may not qualify for relief. This includes debt forgiven on a second home, credit cards, or car loans.

Definition of Cancellation of Debt:
After borrowing money from a commercial lender and the lender cancels/forgives the debt prior to you repaying the loan, you may be required to state that cancelled debt as income for tax purposes. In other words, if you borrow $5,000 and default on the loan after paying back $2,000 and the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $3,000, which is the taxable income to you.

Other Ways Cancelled Debt Income is not Taxable:

·         Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.

·         Insolvency: The exception when your total debts total to more than the fair market value of your total assets. Here, some or all of the cancelled debt may not be taxable.

·         Certain farm debts: Applies to debt incurred directly in the operation of a farm, if more than half your income from three years prior was from farming, and a qualified person/agency cancelled the debt, the debt is generally not taxable income.

Non-recourse loans: This loan occurs when the lender’s only choice in case of default is to repossess the property being financed or used as collateral and the lender cannot pursue you in case of default. Though a non-recourse loan resulting from a foreclosure is not considered cancellation of debt income, there may be other tax consequences.

 

Nothing herein is intended to be legal advice. The above is merely a summary intended to alert the consumer of the issues involved. To get advice on your specific situation, contact the McMillan Law Group at 858-499 8951