Many years ago I was doing a tax return for a couple who had had quite a few major financial setbacks the previous year. They had just barely managed to stay in their home. They had avoided foreclosure because their lender was willing to work with them. Their loan had been totally redone and the lender had “forgiven” $25,000 of the debt. This meant the couple was able to make the payments on their new, smaller loan. After a difficult year financially, they were looking forward to getting a refund when they did their taxes. They were going to use the money to pay off a few credit cards they still owed on.
It was my difficult job to tell them, that in the eyes of the IRS, debt forgiveness is taxable income. When you have a loan for $200,000 and the lender lowers that to $175,000, the IRS treats that as income. From their perspective, it is just the same as earning $25,000 and using it to pay down your debt. My clients were very unhappy when I told them, that only were they not going to get a refund, they now owed the IRS several thousand dollars because of their debt forgiveness. Talk about kicking someone when they are down!
With the current mortgage crisis, many lenders are working with mortgage holders to restructure loans, and they are forgiving part of the principal due. It this housing market it can make a lot of sense. It is better to lose some debt repayment, then to foreclose and get stuck with a house the bank can’t sell.
The IRS has decided to help out homeowners, and for tax years 2007, 2008, and 2009, homeowners will not be required to pay taxes on certain debt forgiveness on mortgages. If you think this will apply to you, make sure to talk with your tax preparer. Certain forms must be filled out, and not all home debt will qualify.
Here are some more details from the IRS.
There is now tax relief for struggling homeowners. If your mortgage debt is partly or entirely forgiven during 2007, 2008 or 2009 you may be able to claim special tax relief by filling out Form 982 and attaching it to your federal income tax return for that year.
Normally, debt forgiveness results in taxable income. But under the Mortgage Forgiveness Debt Relief Act of 2007, you may be able to exclude from tax up to $2 million of debt forgiven on your principal residence. The limit is $1 million for a married person filing a separate return.
Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, may qualify for this relief. The debt must have been used to buy, build or substantially improve your principal residence and must have been secured by that residence. Debt used to refinance qualifying debt is also eligible for the exclusion, but only up to the amount of the old mortgage principal, just before the refinancing.
Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the new tax-relief provision. In some cases, however, other kinds of tax relief, based on insolvency, for example, may be available. See Form 982 for details.
If your debt is reduced or eliminated you will receive a year-end statement (Form 1099-C) from your lender. By law, this form must show the amount of debt forgiven and the fair market value of any property given up through foreclosure.
The IRS urges borrowers to check the Form 1099-C carefully. Notify the lender immediately if any of the information shown is incorrect. You should pay particular attention to the amount of debt forgiven (Box 2) and the value listed for your home (Box 7).
For more information about the Mortgage Forgiveness Debt Relief Act of 2007, visit the IRS Web site at IRS.gov. A good resource is IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments. This publication and Form 982 can be downloaded from IRS.gov or by calling 800-TAX-FORM (800-829-3676).
Remember that for the genuine IRS Web site be sure to use .gov. Don’t be confused by internet sites that end in .com, .net, .org or other designations instead of .gov. The address of the official IRS governmental Web site is www.irs.gov.