Mortgage Debt Forgiveness: Do You Qualify For Tax Relief?

Last updated 03/21/2024 by

From 2007 to 2016, the U.S. saw 7.7 million foreclosures. Today, the rate of mortgage defaults is in decline, but we have yet to reach pre-crisis levels. It is little wonder as to why the home foreclosure situation is this dire. Mortgages represent the largest segment of consumer debt in the United States, standing at $15.8 trillion as of the third quarter of 2019. More than 4.5 million Americans owe more on their house than what it is worth. For these individuals faced with a mortgage crisis, foreclosure is often the only way out.

Foreclosures and short sales often require lenders to forgive part of a mortgage’s balance. If creditors have forgiven part of your mortgage or you’re planning to settle with your lender for less than the agreed balance, you need to know about the consequences of mortgage debt forgiveness.

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What is mortgage debt forgiveness?

Mortgage debt forgiveness occurs when a mortgage lender cancels or forgives some or all of a borrower’s debt. This happens due to principal forgiveness on a mortgage loan, a foreclosure, a short sale, or a deed-in-lieu of foreclosure.

For example, let’s say you purchased a home and ended up defaulting on your mortgage. The lender sold your home to recover the loss, but the foreclosure sale price was lower than the initial balance of the loan. The difference left over is a deficiency for the lender.

If you purchased your home at $200,000, for instance, and the sale price at the time of foreclosure was $175,000, the lender would incur a deficiency of $25,000.

Some lenders may try and recover this deficiency from you. Others, however, will forgive the debt and write it off as a loss. This is known as mortgage forgiveness.

As a borrower, it may be a great relief to learn that your lender will forgive your deficiency amount. However, debt forgiveness comes with a downside. Lenders report any forgiven debt to the IRS using the 1099-C form, and the amount may become taxable income for you.

Is forgiven mortgage debt always taxable?

The IRS doesn’t always consider mortgage debt forgiveness to be taxable income. If any of the following situations apply, you won’t have to pay taxes on your canceled debt:

Non-recourse loans. In the case of default, non-recourse loans restrict the lender from taking any recourse other than repossessing the property. If there is a deficiency, it is automatically forgiven and considered non-taxable.
Bankruptcy. If you file for bankruptcy, the debt that was canceled will not be taxable.
Insolvency. If your total debt exceeds your assets’ total fair market value at the time of foreclosure, you are insolvent. As such, you can receive tax relief on the forgiven debt.
Farm debts (some). Some farm debts are exempt, but the rules here are complex. If this applies to you, consult a tax professional.

If none of these exceptions applies to you, the Mortgage Forgiveness Act could come to your rescue.

The Mortgage Forgiveness Debt Relief Act of 2007

The Mortgage Forgiveness Debt Relief Act was signed into law in 2007. It removes tax liability for qualifying homeowners whose mortgage debt was forgiven. The original act was only active until 2009, but the IRS has extended the policy every year until 2017. However, the current law applies to debt forgiven up to 2017 and even 2018 if there was a written agreement in 2017.

On December 20, 2019, the United States government formally extended this practice when the Further Consolidated Appropriations Act, 2020, was signed into law. For many people, this new piece of legislation comes as a welcome piece of tax law.

Who qualifies for the Mortgage Debt Relief Act?

To qualify for debt relief, you must have used the money to buy, build, or improve your principal residence. Debt forgiveness on credit cards, car loans, rental property, and second homes do not qualify.

Further, the Mortgage Debt Relief Act stipulates that this debt can qualify if it was reduced through mortgage restructuring or foreclosure. If you gained proceeds through refinancing and used them to improve your principal residence, that debt can also qualify.

Also, the relief won’t apply unless the discharge is due to a decline in the home’s value or the taxpayer’s financial condition.

How much mortgage tax debt will the IRS forgive?

The IRS will forgive up to two million dollars on a principal residence and up to one million for a married person who files taxes separately.

How do you claim the tax relief on your tax return?

Just fill out Form 982, ‘Reduction of Tax Attributes Due to Discharge of Indebtedness.’ Attach it to your Federal income tax return for the year the debt was forgiven. For further assistance, you can refer to IRS publication 4681 or contact a tax preparation firm.

Why is the government offering this tax relief?

The IRS provides this ongoing tax relief to minimize hardships for households in distress following the 2008 financial crisis and to prevent a recession. That same year, the IRS launched the Fresh Start Initiative, which made it possible for more people to qualify for mortgage forgiveness. The program was seen as a win-win as many taxpayers could take advantage of mortgage forgiveness debt relief, and the government could recoup revenue they may not have otherwise.

When should you talk to a professional?

You don’t need to hire a tax professional to request debt relief from mortgage debt forgiveness. You can talk directly to the IRS. However, if you have other tax debts (or consumer debt) to worry about, it may be a good idea to hire a tax relief professional. They can help you understand your options and arrange for a settlement.

How much debt has been canceled?

According to the IRS’s latest data, $89.6 billion in canceled debt has been claimed since 2007 (source). These figures include all types of debt cancelation, not just residential. However, the number of forms submitted and the amount of debt increased during the 2008 financial crisis and in the following years.

The amount of forgiven debt has decreased since its peak in 2011. However, levels have started to rise again and are still higher than before the financial crisis, suggesting that taxpayers continue to experience financial distress.

Ten things to consider when dealing with mortgage debt forgiveness

If your lender canceled or forgave your mortgage debt, you generally have to pay tax on that amount. But there are exceptions to this rule for some homeowners.

Here are 10 key facts from the IRS about mortgage debt forgiveness:

1. The canceled debt normally results in taxable income.

However, you may be able to exclude the forgiven debt from your income if the debt was a mortgage on your main home.

2. To qualify, you must have used the debt to buy, build or substantially improve your principal residence.

The residence must also secure the mortgage.

3. The maximum qualified debt that you can exclude under this exception is $2 million.

The limit is $1 million for a married person who files a separate tax return.

4. You may be able to exclude from income the amount of mortgage debt reduced through mortgage restructuring.

You may also be able to exclude this debt canceled in a foreclosure.

5. You may also qualify for the exclusion on a refinanced mortgage.

This applies only if you used proceeds from the refinancing to buy, build or substantially improve your main home. The exclusion is limited to the amount of the old mortgage principal just before the refinancing.

6. Proceeds of refinanced mortgage debt used for other purposes do not qualify for the exclusion.

For example, debt used to pay off credit cards does not qualify.

7. If you qualify, report the excluded debt on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.

Submit the completed form with your federal income tax return.

8. Other types of canceled debt do not qualify for this special exclusion.

This includes debt canceled on second homes, rental and business property, credit cards or car loans. In some cases, other tax relief provisions may apply, such as debts discharged in certain bankruptcy proceedings. Form 982 provides more details about these provisions.

9. If your lender reduced or canceled at least $600 of your mortgage debt, they normally send you a statement in January of the next year.

Form 1099-C, Cancellation of Debt, shows the amount of canceled debt and the fair market value of any foreclosed property.

10. Check your Form 1099-C for the canceled debt amount shown in Box 2, and the value of your home shown in Box 7.

Notify the lender immediately of any incorrect information so they can correct the form. Use the Interactive Tax Assistant tool on IRS.gov to check if your canceled debt is taxable.

Be aware of scammers

The current mortgage crisis has given rise to nefarious types who prey on homeowners desperate for any kind of relief. The most common fraudulent tactic is where someone claiming to represent the government or major lending institutions claims they can help you refinance your house to avoid foreclosure. This is almost always dependent on a large upfront service fee. In the end, the homeowner only finds themselves in a worse financial situation with no legitimate mortgage relief to show for it.

In recent years, the Federal Trade Commission filed more than 35 cases against marketers of mortgage relief services and has worked with law enforcement to stop several more. In 2010, the government introduced the Mortgage Assistance Relief Services (MARS) regulations that are legally binding and aimed at curbing this bad behavior. The MARS regulations prevent companies from taking any money in advance before delivering legitimate mortgage relief services.

To avoid falling victim to one of these scams, look for the following warning signs:

A guarantee that they can prevent foreclosure regardless of your financial situation.
A demand for an upfront fee to provide mortgage relief which is a direct violation of the MARS regulations.
You are told not to contact your lending organization or lawyer before signing.
They claim to be representing the government. No legitimate government official solicits in this manner.

To keep yourself protected, never respond to unsolicited calls or emails offering a too-good-to-be-true relief plan. If you suspect a scammer may have targeted you, contact the FTC directly and register a formal complaint.

Getting started

Are you going through a difficult time that has put your mortgage at risk? Do you need help understanding the details of forgiven debt? Tax relief firms that have tax attorneys on staff can help you. Consulting a qualified tax expert who can walk you through all the tax implications will be well worth the effort.

Jessica Walrack

Jessica Walrack is a personal finance writer at SuperMoney, The Simple Dollar, Interest.com, Commonbond, Bankrate, NextAdvisor, Guardian, Personalloans.org and many others. She specializes in taking personal finance topics like loans, credit cards, and budgeting, and making them accessible and fun.

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