Though the Buffalo area has not been hit as hard by the mortgage crisis as other parts of the country, there are still many local people who are affected. Whether in a foreclosure situation or in negotiating with a lender to accept something less than the full mortgage debt that is owed (a “short sale”), a homeowner may end up having a portion of his or her mortgage debt forgiven by his or her lender. In the past, this may have solved one problem (the inability to satisfy the mortgage) but created another: income tax due on the forgiven debt.
In many circumstances, cancelled or forgiven debt is considered income to the debtor, but there are also a number of exceptions that come into play. Probably the most frequently arising exceptions are debts discharged in bankruptcy and debts forgiven when the debtor is insolvent immediately prior to the forgiveness (though this is limited to the dollar amount of the insolvency).
In December 2007, the Mortgage Forgiveness Debt Relief Act of 2007 was enacted and signed into law. This law allows taxpayers to exclude debt cancellation income up to $2,000,000 from their gross incomes, assuming that the cancelled debt is considered “qualified principal residence indebtedness.” This means, generally, that the debt was incurred to buy, build or improve the home and is secured by the taxpayer’s principal residence. [Note that to the extent that a taxpayer refinances and takes equity in the home to use for other purposes (college tuition, paying other debts, etc.), that additional amount may not qualify for the exclusion from income. The debt forgiven must have been incurred to buy, build or substantially improve the principal residence to qualify. Remember that another exclusion (like insolvency mentioned above) could be available, depending upon the circumstances.]
If a debt (or a portion of a debt) is forgiven, the amount forgiven should be reported by the lender to the taxpayer on a Form 1099-C. The taxpayer would then file a Form 982 with his or her federal income tax return for the year of the transaction to report the excluded “discharge of indebtedness” income, but it will not be added to his or her gross income.
At this time, the “qualified principal residence indebtedness” exclusion only applies to debt forgiven in 2007, 2008 and 2009. Let’s hope that the crisis will have passed, and we will no longer need it by then . . .