Forgiveness of Debt Income

Having a lender foreclose on your home is generally one of the more traumatic events of a person’s life. But it can get even worse.  Prior to the Mortgage Forgiveness Debt Relief Act of 2007, the person who has just lost her home could be required to pay income taxes on “forgiveness of debt income.”

The reason for the tax is that, from the point of view of the tax law, the person has sold the home. The amount “received” from  the “sale “ is the amount paid by the party that purchases the home at the foreclosure sale, plus any debt relief given by the lender, if the amount of the loan was more than the amount paid at the foreclosure sale.

Here’s an example:

Judy buys a house for $125,000, paying $6250 down and signing a mortgage note for $118,750. When the loan balance has been paid down to $112,750, Judy loses her job and can no longer afford the mortgage payments. The lender forecloses and purchases the house at foreclosure for $100,000. Judy receives Form 1099 from the lender, showing cancellation of debt income in the amount of $12,750.

In real terms, Judy has a loss of $12,250 – her down payment and the amount of principal she has paid on the note. But she cannot deduct the loss on her tax return, because the house was personal-use property, for which losses cannot be recognized for tax purposes. Prior to the Mortgage Forgiveness Debt Relief Act of 2007, Judy would have had to report  $12,750 of “other income” on her tax return.

Under  the Mortgage Forgiveness Debt Relief Act of 2007, cancellation of indebtedness income is excluded from a taxpayer’s gross income if the debt was “ qualified principal residence indebtedness” discharged (cancelled) in 2007, 2008, or 2009. Qualified principal residence indebtedness means debt associated with buying or substantially improving the home, up to $2 million (or $1 million if a person uses married-filing-separately status).  Qualified principal residence indebtedness  also includes refinancing, to the extent the amount of the refinancing does not exceed the amount of the original loan(s).