Tax Relief for Cancelled Mortgage Debt
So, you are one of the thousands of Americans who lost a home to foreclosure during the year. It is a pretty tough time for many home owners. Thanks to legislation passed in 2007 you just might have been granted a wish from Uncle Sam.
There was a time when people who lost a home to foreclosure were inflicted with a double dose of pain and suffering. Before the Mortgage Debt Relief Act of 2007, people who lost their homes to foreclosure often had their outstanding home mortgage cancelled by their lender. However, most homeowners did not understand that this cancelled debt was considered taxable income by the IRS. This law is set to expire at the end of 2013, so debt cancelled in 2014 or later is set to be considered income in the year received.
Let’s look at an example: A buyer purchases a $200,000 with no money down by taking out a $200,000 interest-only mortgage. Afterwards, if the buyer can’t make the mortgage payments, the bank forecloses on the loan and takes back the house.
After the foreclosure the bank sells the house for $150,000 – which is less than the remaining loan amount. This leaves an unpaid loan balance of $50,000. Depending on the loan, the person who lost their home might still be responsible for the unpaid part of the mortgage – $50,000. If the bank doesn’t think they can get the money from the person then the bank will often “walk away” and cancel the debt.
Now comes the taxable income – if someone loans you money and then you don’t have to pay it back, it is considered income to you. This is fully taxable – talk about salt-in-the-wound. You will know that you have been struck by this when you receive a special form from your lender called a 1099-C.
But don’t let this second disaster get you down. The legislation passed by congress in 2007 and 2008 eased the pain for most people who lost their home to foreclosure. The new law covers seven years – 2007 to 2013 – before the old law kicks back in.
What's covered and what's not
- This relief applies only to principal residences, that is, the home you live in. For example, if a lender forgives debt after a foreclosure, short sale, or loan restructuring for a vacation home or investment property, the old rule still applies: The amount of debt cancelled is considered taxable income to you (unless you qualify for one of the exceptions discussed later).
- No more than $2 million of forgiven principal residence debt can be excluded from income.
- To be eligible for the break, the loan must be secured by your principal residence and the money must have been used to buy, build or substantially improve the home. If part of the forgiven debt was a home equity loan used for other purposes that part would be considered taxable income.
- The “tax basis” or “cost basis” of the home is reduced by the amount of cancelled debt excluded from income. The basis is the amount you compare to the selling price of the home to determine if you have a profit or loss. For tax purposes, a foreclosure is treated the same as a sale. For example, if a loan restructuring results in cancellation of $25,000 of debt, your basis would be reduced by $25,000. This could increase your profit up to $25,000 when you later sell the home.
You should receive a Form 1099-C for the year in which debt of $600 or more is cancelled. You usually will receive this form in January or February of the year after the debt is cancelled – about the same time you receive the rest of your tax forms such as W-2s and 1099s. So, for debt cancelled in 2013, you should receive a 1099-C sometime in early 2014.
The 1099-C will show the amount of debt forgiven and the fair market value of property that you gave up to the lender through the foreclosure. The IRS urges you to check the form carefully and notify the lender immediately if any of the information shown on their form is incorrect. Pay close attention to the amount of debt forgiven (Box 2) and the value listed for your home (Box 7).
Sometimes, rather than trying to take back a home, a lender will allow a borrower to sell the house for less than the mortgage amount. This is called a “short sale”.
Let’s look at example - Say you lost your job and can't keep up the payments on your home. You still owe $300,000 on your mortgage, but the house value has dropped to $275,000. If the bank agrees to a short sale, you'd sell the house, pay the commission and other selling costs – let's assume $15,000 – and turn the remaining $260,000 over to the bank. If the bank then forgives the $40,000 gap between this $260,000 payment and the $300,000 mortgage balance, the forgiven $40,000 would show up as cancelled debt on Form 1099-C. This $40,000 is usually considered taxable income.
But, thanks to those 2007 and 2008 tax law changes, when a short sale in 2007 through 2013 involves a principal residence, the cancelled debt is not considered taxable income within the limits explained earlier.
If you’re not covered by the special tax break for principal residences described above, there are two very important exceptions to the “cancelled debt = taxable income” rule.
The cancelled debt is not income, even if you receive a Form 1099-C, if
- You received the cancelled debt due to bankruptcy filing, or
- To the extent you are insolvent immediately before the cancellation of the debt.
Insolvency means your debts exceed the value of all your assets. You can exclude cancelled debt from income up to the amount that you are insolvent. For example, if you had assets of $80,000 and debt of $100,000, you are considered to insolvent by $20,000. If you had $30,000 in debt cancelled at this time of insolvency, you would have to include only $10,000 ($30,000 minus $20,000) in your income.
Cancelled debt can be a challenging tax situation especially during hard financial times. TurboTax will guide you through the cancelled debt maze, including the new legislation, and help minimize the pain from in these tough situations.