Happy Tax Season Series: Mortgage Debt Forgiveness – Is it Taxable?

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February 29, 2012 by msquaredlaw

When someone forgives a debt you owe, the amount of the canceled debt is normally taxable to you.  However, there are some exceptions.  One of those exceptions is found in the Mortgage Forgiveness Debt Relief Act of 2007 and is available to homeowners whose mortgage debt is partly or entirely forgiven during tax years 2007 through 2012.

The following are some important points:

1.  Amount of Debt Forgiven.  You may be able to exclude up to $2 million of debt forgiven on your principal residence.  The limit is $1 million for a married person filing a separate return.

2.  Method of Debt Forgiveness/Reduction.  You may exclude debt reduced through mortgage restructuring, as well as mortgage debt forgiven in a foreclosure.

3.  Type of Debt.  To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence.  Refinanced debt proceeds used for the purpose of substantially improving your 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.

4.  Claiming the Exclusion.  If you qualify, claim the special exclusion by filling out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attach it to your federal income tax return for the tax year in which the qualified debt was forgiven.

5.  Debt that Does Not Qualify.  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 the exception for insolvency – may be applicable.  IRS Form 982 provides more details about these provisions.

6.  Form 1099-C.   If your debt is reduced or eliminated you normally will receive a year-end statement, Form 1099-C, Cancellation of Debt, from your lender. By law, this form must show the amount of debt forgiven and the fair market value of any property foreclosed.  Examine the Form 1099-C carefully.  Notify the lender immediately if any of the information shown is incorrect.  You should pay particular attention to the amount of debt forgiven in Box 2 as well as the value listed for your home in Box 7.

For more information see IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments.   Please contact us if you need assistance.

Muiños & Morales

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