A lender will, on occasion, forgive some portion of a borrower’s debt.  The general tax rule that applies to any debt forgiveness is that the amount forgiven is treated as taxable income to the borrower.  Some exceptions to this rule are available, but, until recently, the borrower was required to pay tax on the debt forgiven.  A new law enacted in December, 2007 provides relief to troubled borrowers when some portion of mortgage debt is forgiven.  However, this relief expires on December 31, 2012 and the National Association of Realtors will be working to obtain an extension throughout the year.

Below is some general information you need to know about his law and cancellation of mortgage debt.

General Rule for Debt Forgiveness

If a lender forgives some or all of an individual’s debts, the general rule is that the forgiven amount is treated as ordinary income and the borrower must pay tax on the forgiven amount.  Exceptions apply for bankruptcy, insolvency and certain other situations, including mortgage debt.

Current Law for Mortgage Debt

(January 1, 2007 through December 31, 2012)  A borrower can be excused from paying tax on forgiven mortgage debt.  The debt must be secured by a principal residence and the total amount of the outstanding obligation may not exceed the original mortgage amount plus the cost of any improvements.

Does the relief apply only to a sale?

No.  The provision has broader application.  Lenders might forgive some portion of mortgage debt in a short sale (when value at sale is less that the amount owed) or in a foreclosure where the debt is wiped out.  In addition, if a borrower still living in the home is able to make an arrangement with a lender that reduces the principal balance of a mortgage the amount forgiven in the workout will not be taxed.

Can the homeowners in a short sale or foreclosure claim a loss?

No.  The loss is considered a personal loss and is, therefore ineligible for either capital loss or ordinary loss treatment.

What happens to the seller when mortgage debt is forgiven?

Until January 2, 2013, the homeowner will pay no tax on any forgiven amount.

Does this provision apply to a refinanced mortgage?

Only in limited circumstances.  The relief provision can apply to either an original or a refinanced mortgage.  If the mortgage has been refinanced at any time, the relief is available only up to the amount of the original debt (plus the cost of any improvements).  Tax relief is generally not available for second mortgages or home-equity lines of credit where the funds are not used for home improvement.  Any amount that is not eligible for the relief provision will be taxed as ordinary income.

How does the homeowner get the correct information to the IRS?

The lender is required to provide the homeowner and the IRS with a Form 1099 reflecting the amount of the forgiven debt.  The borrower/homeowner must file a Form 982 to reflect the amount forgiven and to show the reason why the forgiven amount is not taxable.  Any taxable portion of forgiven debt, will then be reported on the homeowner’s Form 1040 for the tax year in which the debt was forgiven.

What if a property declines in value but the owner stays in the house?

The provision would not apply.  The provision applies only at the time of sale or other disposition or when there is a workout (reduction of existing debt) with the lender.

Do all lenders forgive mortgage debt when property values decline or the home is in foreclosure?

No.  Some states have laws that allow a lender to require a repayment arrangement, particularly if the borrower has other assets.  Forgiveness of debt is always at the lender’s discretion.