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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 ($1million 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.
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 canceled 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.
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 canceled, some or all of the
canceled 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 canceled 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.
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 A - Figuring Cancellation of Debt Income (Note: For non-recourse loans,
skip this section. You have no income from cancellation of debt.)
Enter the total amount of the debt immediately prior to the
foreclosure.___________
Enter the fair market value of the property
from Form 1099-C, box 7. ___________
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.
Enter the fair market value of the property
foreclosed.For non-recourse loans, enter the amount of the debt
immediately prior to the foreclosure ________
Enter your adjusted
basis in the property.(Usually your purchase price plus the cost of any
major improvements.) ____________
Subtract line 2 from line 1. If
less than zero, enter zero.
The amount on line 3 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.
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.
Some 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 A - Figuring Cancellation of Debt Income (Note: For non-recourse loans,
skip this section. You have no income from cancellation of debt.)
Enter the total amount of the debt immediately prior to the
foreclosure.___$220,000__
Enter the fair market value of the
property from Form 1099-C, box 7. ___$200,000__
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 B – Figuring Gain from Foreclosure
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__
Enter your adjusted basis in the
property.(Usually your purchase price plus the cost of any major
improvements.) ___$170,000__
Subtract line 2 from line 1 If less
than zero, enter zero.___$30,000__
The amount on line 3 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”.
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.
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.
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.
Related Items:
Publication 523, Selling Your Home
Publication 544, Sales and Other Dispositions of Assets
