| Update Feb. 4, 2008 — The
Mortgage Forgiveness Debt Relief Act
of 2007 generally allows taxpayers
to exclude income from the discharge
of debt on their principal
residence. Debt reduced through
mortgage restructuring, as well as
mortgage debt forgiven in connection
with a foreclosure, qualify for this
relief. This provision
applies to debt forgiven in 2007,
2008 or 2009. Up to $2 million of
forgiven debt is eligible for this
exclusion ($1 million if married
filing separately). The exclusion
doesn’t apply if the discharge 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 amount excluded reduces
the taxpayer’s cost basis in the
home. More information on claiming
this exclusion will be available
soon.
The questions and answers,
below, are based on the law prior to
the passage of the Mortgage
Forgiveness Debt Relief Act of 2007.
1. What is Cancellation of
Debt?
If you borrow money from a
commercial lender and the lender
later cancels or forgives the debt,
you may have to include the
cancelled amount in income for tax
purposes, depending on the
circumstances. When you borrowed the
money you were not required to
include the loan proceeds in income
because you had an obligation to
repay the lender. When that
obligation is subsequently forgiven,
the amount you received as loan
proceeds is reportable as income
because you no longer have an
obligation to repay the lender. The
lender is usually required to report
the amount of the canceled debt to
you and the IRS on a Form 1099-C,
Cancellation of Debt.
Here’s a very simplified example.
You borrow $10,000 and default on
the loan after paying back $2,000.
If the lender is unable to collect
the remaining debt from you, there
is a cancellation of debt of $8,000,
which generally is taxable income to
you.
2. Is Cancellation of Debt
income always taxable?
Not always. There are some
exceptions. The most common
situations when cancellation of debt
income is not taxable involve:
- Bankruptcy: Debts discharged
through bankruptcy are not
considered taxable income.
- Insolvency: If you are
insolvent when the debt is
cancelled, some or all of the
cancelled debt may not be
taxable to you. You are
insolvent when your total debts
are more than the fair market
value of your total assets.
Insolvency can be fairly complex
to determine and the assistance
of a tax professional is
recommended if you believe you
qualify for this exception.
- Certain farm debts: If you
incurred the debt directly in
operation of a farm, more than
half your income from the prior
three years was from farming,
and the loan was owed to a
person or agency regularly
engaged in lending, your
cancelled debt is generally not
considered taxable income. The
rules applicable to farmers are
complex and the assistance of a
tax professional is recommended
if you believe you qualify for
this exception.
- Non-recourse loans: A
non-recourse loan is a loan for
which the lender’s only remedy
in case of default is to
repossess the property being
financed or used as collateral.
That is, the lender cannot
pursue you personally in case of
default. Forgiveness of a
non-recourse loan resulting from
a foreclosure does not result in
cancellation of debt income.
However, it may result in other
tax consequences, as discussed
in Question 3 below.
3. I lost my home through
foreclosure. Are there tax
consequences?
There are two possible
consequences you must consider:
- Taxable cancellation of debt
income. Note: As stated above,
cancellation of debt income is
not taxable in the case of
non-recourse loans.)
- A reportable gain from the
disposition of the home (because
foreclosures are treated like
sales for tax purposes). (Note:
Often some or all of the gain
from the sale of a personal
residence qualifies for
exclusion from income.)
Use the following steps to
compute the income to be reported
from a foreclosure:
Step 1 - Figuring
Cancellation of Debt Income
(Note: For
non-recourse loans, skip this
section. You have no income
from cancellation of debt.)
1. Enter the total amount of
the debt immediately prior to
the foreclosure.___________
2. Enter the fair market value
of the property from Form
1099-C, box 7. ___________
3. Subtract line 2 from line
1.If less than zero, enter
zero.___________
The amount on line 3 will
generally equal the amount shown in
box 2 of Form 1099-C. This amount
is taxable unless you meet one of
the exceptions in question 2. Enter
it on line 21, Other Income, of your
Form 1040.
Step 2 –
Figuring Gain from Foreclosure
4. Enter the fair market
value of the property
foreclosed. For non-recourse
loans, enter the amount of the
debt immediately prior to the
foreclosure ________
5. Enter your adjusted basis
in the property. (Usually your
purchase price plus the cost of
any major
improvements.)
____________
6. Subtract line 5 from line 4.
If less than zero, enter
zero.
The amount on line 6 is your gain
from the foreclosure of your home.
If you have owned and used the home
as your principal residence for
periods totaling at least two years
during the five year period ending
on the date of the foreclosure, you
may exclude up to $250,000 (up to
$500,000 for married couples filing
a joint return) from income. If you
do not qualify for this exclusion,
or your gain exceeds $250,000
($500,000 for married couples filing
a joint return), report the taxable
amount on Schedule D, Capital Gains
and Losses.
4. I lost money on the foreclosure
of my home. Can I claim a loss on
my tax return?
No. Losses from the sale or
foreclosure of personal property
are not deductible.
5. Can you provide examples?
A borrower bought a home in
August 2005 and lived in it until it
was taken through foreclosure in
September 2007. The original
purchase price was $170,000, the
home is worth $200,000 at
foreclosure, and the mortgage debt
canceled at foreclosure is $220,000.
At the time of the
foreclosure, the borrower is
insolvent, with liabilities
(mortgage, credit cards, car loans
and other debts) totaling $250,000
and assets totaling $230,000.
The borrower figures income from
the foreclosure as follows:
Use the following steps to
compute the income to be reported
from a foreclosure:
Step 1 - Figuring
Cancellation of Debt Income
(Note: For non-recourse
loans, skip this section. You have
no income from cancellation of
debt.)
1. Enter the total amount of
the debt immediately prior to
the foreclosure.___$220,000__
2. Enter the fair market value
of the property from Form
1099-C, box 7. ___$200,000__
3. Subtract line 2 from line
1.If less than zero, enter
zero.___$20,000__
The amount on line 3 will
generally equal the amount shown in
box 2 of Form 1099-C. This amount
is taxable unless you meet one of
the exceptions in question 2. Enter
it on line 21, Other Income, of your
Form 1040.
Step 2 – Figuring Gain from
Foreclosure
4. Enter the fair market
value of the property
foreclosed. For non-recourse
loans, enter the amount of the
debt immediately prior to the
foreclosure. __$200,000__
5. Enter your adjusted basis in
the property. (Usually your
purchase price plus the cost of
any major
improvements.)
___$170,000__
6. Subtract line 5 from line
4.If less than zero, enter
zero.___$30,000__
The amount on line 6 is your gain
from the foreclosure of your home.
If you have owned and used the home
as your principal residence for
periods totaling at least two years
during the five year period ending
on the date of the foreclosure, you
may exclude up to $250,000 (up to
$500,000 for married couples filing
a joint return) from income. If you
do not qualify for this exclusion,
or your gain exceeds $250,000
($500,000 for married couples filing
a joint return), report the taxable
amount on Schedule D, Capital Gains
and Losses.
In this situation, the borrower
has a tax-free home-sale gain of
$30,000 ($200,000 minus $170,000),
because they owned and lived in
their home as a principal residence
for at least two years. Ordinarily,
the borrower would also have taxable
debt-forgiveness income of $20,000
($220,000 minus $200,000). But since
the borrower’s liabilities exceed
assets by $20,000 ($250,000 minus
$230,000) there is no tax on the
canceled debt.
Other examples can be found in
IRS Publication 544, Sales and Other
Dispositions of Assets, under the
section “Foreclosures
and Repossessions”.
6. I don’t agree with the
information on the Form 1099-C.
What should I do?
Contact the lender. The lender
should issue a corrected form if the
information is determined to be
incorrect. Retain all records
related to the purchase of your home
and all related debt.
7. I received a notice
from the IRS on this. What should I
do?
The IRS urges borrowers with
questions to call the phone number
shown on the notice. The IRS also
urges borrowers who wind up owing
additional tax and are unable to pay
it in full to use the installment
agreement form, normally included
with the notice, to request a
payment agreement with the agency.
8. Where else can I go to get tax
help?
If you are having difficulty
resolving a tax problem (such as one
involving an IRS bill, letter or
notice) through normal IRS channels,
the
Taxpayer Advocate Service may be
able to help. For more information,
you can also call the TAS toll-free
case intake line at 1-877-777-4778,
TTY/TDD 1-800-829-4059.
In some cases, you may qualify
for free or low-cost assistance from
a Low Income Taxpayer Clinic (LITC).
LITCs are independent organizations
that represent low income taxpayers
in tax disputes with the IRS. Find
information on an LITCs in your
area.
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