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The Mortgage Forgiveness Debt Relief Act of 2007

- Tuesday, October 23, 2012

The Mortgage Forgiveness Debt Relief Act of 2007 became law on December 20, 2007. The aim of the Mortgage Forgiveness Debt Relief Act is to protect homeowners who have lost their home through foreclosure, or who have taken action to avoid foreclosure through a short sale or mortgage modification, from the double hit of having to then pay income tax on their forgiven mortgage debt.

Normally, forgiven debt is considered by IRS to be the same as taxable income. For example, if your lender forgives $100,000 of your mortgage debt, whether through foreclosure or via a short sale, that $100,000 would be considered taxable income for the year that that debt was forgiven. However, in recognition of the global financial crisis that has resulted in millions of American homeowners struggling to pay their mortgages, the Act was passed as a special provision, to relieve these homeowners of having to pay income tax on the forgiven debt.

The Mortgage Forgiveness Debt Relief Act originally applied only to homeowners who were foreclosed upon, or whose debt was forgiven, between January 1, 2007, and December 31, 2009. Its expiry date has since been extended to December 31, 2012. It is possible that that expiry date will be extended further, but so far no decision has been made about an extension.

The Mortgage Forgiveness Debt Relief Act applies only to mortgage debt that was owing on your principal residence. For your home to qualify as “principal residence”, you must have both owned the home and used the home as your principal residence for periods aggregating 2 years or more during the 5-year period ending on the date of the sale or exchange of the home. Other things to know:

  • The maximum amount you can treat as qualified principal residence indebtedness is $2 million, or $1 million if married and filing separately.
  • The Act applies to debt that is forgiven through foreclosure, through a short sale, or through modification of the terms of the mortgage. Forgiven debt is normally considered by IRS to be income. In IRS terms, what the Act does is allow you to “exclude” this income when filing your tax return.
  • The forgiven debt must have been used to buy, build, or substantially improve the residence. In other words, forgiven debt on both first and second mortgages can be included under the Act provided that the debt was used for one of those purposes - but not if it was used for other purposes, e.g. to pay off credit cards or to buy a new car.
  • The forgiven debt must be secured by that same residence.
  • Refinanced debt proceeds may also qualify for exclusion under the Act, provided that they were used to “substantially improve” the residence and not for other purposes.
  • Debt that has been forgiven on second homes or investment homes does not qualify for exclusion under the Act - but it may be exempt from income tax due to other exclusions such as Insolvency.

If your lender forgives more than $600 of your debt, they are required by law to issue you a 1099-C, Cancellation of Debt form. Make sure that you examine the form as soon as you receive it. Check that the amount of debt forgiven (listed in Box 2), and the fair market value listed for your home (Box 7) are both correct. If there are any problems with the form, have your lender correct them immediately.

To exclude forgiven debt from taxable income, fill out IRS Form 982 and attach it to your income tax return.

For more detailed information about excluding forgiven debt from your taxable income, through the Mortgage Forgiveness Debt Relief Act and through other exclusions such as Insolvency and Bankruptcy, download IRS Publication 4681.

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