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Mortgage Glossary
Canceled Debt and Mortgage Forgiveness
 
Citizens who have lost their houses during foreclosure or who have restructured their mortgage loans may qualify for tax relief under a new tax law, the Mortgage Forgiveness Debt Relief Act of 2007. The tax relief was extended to cover the years 2007 through 2012 under the emergency stabilization act.

Attractions of Mortgage Debt Relief
  1. Exclude up to $2 million of debt forgiven or canceled by a mortgage lender on a main home.
  2. Both mortgage restructuring and foreclosures qualify.
  3. Available for the years 2007 through 2012.
  4. Claim the tax relief using IRS Form (PDF).
Canceled Debt Income:
Anytime a lender cancels, or forgives, your debt, that is considered income to the debtor. The tax laws consider this income, and the defaulter is taxed on forgiven debt unless an exception applies.

Canceled Debt that is Taxable:
Anytime a lender cancels or excuses debt that is usually a taxable event. Normally, if a debt you owe is canceled or forgiven, you must include the canceled amount in your income. Debt forgiveness is reported by the lender using Form 1099-C, Cancellation of Debt. Individuals report the forgiven debt on their Form 1040, Line 21 as other income.

The tax laws provide several exceptions to the tax treatment of forgiven debts. Tax-free treatment of mortgage debt is the most generous and easiest to calculate.

How Mortgage Restructuring Stops Foreclosure?
Mortgage restructuring allows qualified borrowers the opportunity to modify the terms of their existing loan in order to stop foreclosure. Restructured terms may include an agreement between the parties to place the amounts in default onto the loan principal allowing the borrower to recommence its regular payment thus removing the borrower from default status. Or, it could entail an increase in the terms of the borrower's current loan to lower mortgage payments, renegotiating an adjustable rate to a more stable and affordable fixed rate or negotiating to lower mortgage rates on a higher fixed-rate loan. The IRS explains the tax break this way: "Taxpayers can exclude up to $2 million of debt forgiven on their principal residence. The limit is $1 million for a married person filing a separate return. This provision applies to debt forgiven in 2007, 2008 or 2009. Debt reduced through mortgage restructuring, as well as mortgage debts forgiven in connection with a foreclosure qualify for this relief.

Other Exclusions for Canceled Debts:
Besides the provision for mortgages on main homes, the tax code offers other ways that canceled debt can be tax-free. Canceled debts do not need to be included in taxable income if the debt was canceled in a bankruptcy case, if the individual is bankrupt, or if the canceled debt was proposed as a gift. Certain business or farm property may also qualify for tax-free treatment. The insolvency exclusion is particularly relevant, as it will likely apply to borrowers with home equity loans or mortgages on second homes and rental properties.

This insolvency provision will prove helpful to individuals who don't otherwise qualify for the mortgage debt relief. To be considered insolvent, the person's liabilities must exceed the fair market value of their assets.