If a debtor owes money to a bank and the bank forgives or cancels any part or all of the debt, the canceled amount may be taxable income.
When a homeowner is “upside down” on their mortgage debt, and is lost in a home foreclosure, the taxpayer may incur cancellation of debt income.
Generally, when a bank renegotiates or forecloses on a loan, if the loan is a recourse loan, the homeowner may still owe the bank for unrecovered mortgage debt. This cancellation of debt may be considered income to the homeowner. This is true if the debt is either partially or completely forgiven through a mortgage workout, or if the loan ends up in foreclosure.
With many homeowners seeking help in renegotiating their mortgages and others losing their homes through foreclosure, Congress realized this was a real problem area, so they passed legislation to fix it. The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. This debt relief is available for tax years 2007 through 2012.
Under the Mortgage Forgiveness Debt Relief Act of 2007, a homeowner may be able to exclude from tax up to $2 million of debt forgiven on their principal residence. The debt must have been home acquisition debt in order to qualify.
Acquisition debt is debt used to buy, build or improve a home. Refinancing and taking on additional debt in excess of $100,000 is normally not acquisition debt.
For example, a homeowner bought their home years ago for $200,000. Over the years the homeowner did multiple refinances, taking additional equity out of the home, and now they owe $450,000. If the homeowner then loses the home in a foreclosure, he probably has at least $250,000 of cancellation of debt income. This situation usually results in debt that cannot be excluded.
In some cases, other kinds of tax relief – based on insolvency, for example – may be available. Taxpayers who have lost their home in a foreclosure, or those that have renegotiated their mortgages, decreasing the balance owed, may end up with a large tax bill. These taxpayers should seek professional tax advice to resolve the problem.
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