Mortgage Debt Forgiveness and the IRS

With the collapse of the economy and crash in the real estate market, more and more homeowners are finding that their home is “underwater” in the sense that the value of the their property is worth significantly less than the mortgage or mortgages that are owed on the property.

Because of the economic conditions our country is laboring under, many homeowners are simply unable to continue to debt service their existing mortgage.  For those homeowners a foreclosure, short sale, deed in lieu or for the lucky ones a negotiated modification of the existing loan balance are but some of the many alternatives.

Debt reduced by a mortgage loan modification, short sale or foreclosure will often result in the issuance by the lender of an IRS Form 1099–C, Cancellation of Debt.  Under the Internal Revenue Code  if you borrow money from a lender who later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes. This is because. 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.

There are some common exceptions to the general rule that cancellation of debt is taxable as income. The most often used exceptions are the bankruptcy and insolvency exceptions.

The bankruptcy exception provides that  debts discharged through bankruptcy are not considered taxable income. Thus if you lose your home through foreclosure, enter into a modification of principal or short sale the home and then file for Chapter 7 bankruptcy, you will not be subject to the requirement that your cancelled debt be included as income.

A second related exception is the insolvency exception. Much like the bankruptcy exception, if you are insolvent when the debt is cancelled some or all of the cancelled debt may not be taxable. You are considered insolvent under this exception when your total debts are more than the fair market value of your total assets.