Cancellation of Mortgage Debt

What You Need to Know about Cancellation of Mortgage Debt

Posted By susanne On March 11, 2012 @ 1:07 pm In Consumer News and Advice,Home Owner News,Real Estate Information,Today’s Top Story,Today’s Top Story – Consumer | No Comments

[1]This column is brought to you by the NAR Real Estate Services group.

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 NAR will be working to obtain an extension throughout the

Below is some general information you need to know about this 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

Current Law for Mortgage Debt
(Jan. 1, 2007 through Dec. 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

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
than 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 that 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 1, 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

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.

Linda Goold is the Tax Counsel for National Association of REALTORS®

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