Forgiven Debt May Be Considered Income by the IRS

As many Americans rush to file their 2011 taxes to meet the April 17th deadline, some may wonder whether they have to pay tax on forgiven mortgage debt. Many individuals who have had mortgage debt forgiven after successfully negotiating with a mortgage company may find they owe tax on the forgiven debt, though there are exceptions to the rule.

Income Tax on Forgiven Debt

The IRS requires individuals to pay income tax on forgiven mortgage debt. Historically, this includes any loan modifications that reduced the total amount owed on a mortgage and mortgage debt forgiven in the event of a foreclosure.

The IRS provides this simplified example on its website: If a homeowner had a loan of $10,000, paid back $2,000, then defaulted on the loan, there was a cancelation of debt of $8,000 and that $8,000 is taxable income. Any amount of canceled debt over $600 must be reported to the IRS, even if it qualifies for some of the following exclusions.

What Types of Forgiven or Canceled Debt is Non-Taxable

Fortunately, a law passed in 2007 protects homeowners who have had mortgage debt forgiven through foreclosure. The Mortgage Forgiveness Debt Relief Act applies to most homeowners who have had debt forgiven on their principal residences. Rental or business properties are not eligible. The forgiven debt must exceed $600 but be less than $2 million and been forgiven between 2007 and 2012.

Other canceled debt may also be non-taxable. Debts discharged through bankruptcy are not considered taxable income. Homeowners that can claim insolvency may also be exempt from paying tax on canceled mortgage debt. A homeowner can claim insolvency if his or her debts are worth more than all of his or her assets.

Before assuming debt is taxable or non-taxable, homeowners should consult with an experienced bankruptcy attorney who can explain whether or not homeowners are eligible for tax exclusions on forgiven or canceled mortgage debt.

Source: Huffington Post, “Your Bank Forgave Your Mortgage Debt, but Will the IRS?” Anna Cuevas, Mar. 19, 2012