According to the IRS, taxable income generally results when a lender cancels a borrower’s debt other than as a gift or bequest. Prior to December 2007 this was true unless the debt was cancelled incident to bankruptcy, while the borrower was insolvent, or a couple of other arcane reasons. If the cancelled debt was greater than $600 lenders issued a 1099 C – cancellation of debt, to report the debt forgiveness to the IRS as well as to the borrower. Box 2 indicated the amount of debt forgiven.

With the recent rise in foreclosures and short sales, Congress realized that distressed homeowners were being hit with large tax liabilities arising out of a change in their financial circumstances that caused them to be unable to make their mortgage payments. Obviously these homeowners were likely not going to be in a position to pay the tax either! Thus was born the Mortgage Forgiveness Debt Relief Act of 2007.

Under the act, homeowners whose mortgage debt is cancelled in whole or in part are generally not liable for federal income tax on the cancelled debt. This is true whether the debt relief is incident to foreclosure, short sale or a restructuring of a mortgage loan. The debt cancelled must be what is referred to as “Qualified Principal Residence Indebtedness” – debt incurred to buy, build, or substantially improve a principal residence, or debt incurred to refinance such a loan. The debt must be secured by the residence. Qualified principal residence indebtedness cannot exceed $2 million ($1 million if married filing separately). Furthermore the borrower must demonstrate that the debt cancellation was directly related to a decline in the fair market value of the home, or deterioration in the taxpayer’s financial situation.

The act has since been extended and now covers the period 2007-2012. Borrowers will still receive a 1099C and the debt forgiveness will still be reported to the IRS. The IRS recommends, by the way, that recipients review the amounts in box 2 and box 7 (which reports the fair market value of the property) and contact the lender if there are any discrepancies. What’s new is that taxpayers report the debt cancellation on form 982, which must be attached to the tax return, and if all the conditions are met, the cancelled debt will not be included in taxable income. If the borrower continues to own the home, the home’s basis must be decreased by the amount of the debt cancellation (though not below zero).

Debt cancellation on second homes and investment property is not covered under the act, though it might be exempt from income tax under one of the other conditions mentioned above. Also, debt cancellation may result in numerous other consequences, such as damaged credit. Since this article is intended to be a brief synopsis of some very complex rules, distressed borrowers and their RealtorsÒ are advised to seek the advice of a CPA or an attorney.