Goldstein & Levy, P.A., General Counsel
March 30, 2012 | Taxation Of Forgiven Indebtedness and the Mortgage Forgiveness Debt Relief Act Of 2007
Taxation of Forgiven Debt
Generally, if you owe a debt to a lender and the lender cancels or forgives that debt, the cancelled amount may be taxable. The theory is that the money you received when you borrowed it was not included in your income and was not taxed because you were obligated to repay it. When that obligation is forgiven, the amount you received as loan proceeds becomes reportable as income become you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to the taxpayer and the IRS on a form 1099-C, Cancellation of Debt. Simple example: You borrow $50,000 and default after paying back $25,000. If the lender forgives and does not seek to collect the unpaid debt from you there is a cancellation of $25,000 of debt which is generally taxable to you as ordinary income.
Is Cancellation of Debt income always taxable?
No, there are some exceptions which render cancelled debt non-taxable, the most common of which are as follows:
- Bankruptcy: debts discharged through bankruptcy are not considered taxable income
- Non-recourse loans: A loan for which the lender’s only remedy in case of default is to repossess the property used as collateral does not create forgiven debt income if the debt is not paid
- Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts exceed the value of all of your assets
- Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners (see below)
Mortgage Forgiveness Debt Relief Act of 2007
- Generally, the Act allows for the exclusion of income realized as a result of the lender’s forgiveness of indebtedness on your principal residence, resulting from loan modification, short sale or foreclosure sale
- ONLY applies to forgiven or cancelled debt used to BUY, BUILD OR SUBSTANTIALLY IMPROVE your principal residence or to refinance debt incurred for these purposes
- The maximum amount of debt that qualifies for this exemption is $2 million, if married, filing jointly, or $1 million, if filing separately
- This Act applies to principal residence debt forgiven in calendar years 2007 through 2012 (unless extended by Congress). NOTE THAT THIS FORGIVENESS PROVISION WILL EXPIRE 12/31/12 UNLESS EXTENDED BY CONGRESS!
- If forgiven debt is excluded from income it must be reported on Form 982 and this form must be attached to your tax return
- For more detailed information go to: http://www.irs.gov/pub/irs-pdf/p4681.pdf
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