What You Need to Know about Cancellation of Mortgage Debt

A lender will, on occasion, forgive some portion of a borrower's debt. The
general tax rule that applies to any debt forgiveness is that the amount
forgiven is treated as taxable income to the borrower. Some exceptions to
this rule are available, but, until recently, the borrower was required to
pay tax on the debt forgiven. A new law enacted in December 2007 provides
relief to troubled borrowers when some portion of mortgage debt is
forgiven. However, this relief expires on December 31, 2012 and NAR will
be working to obtain an extension throughout the year.

Below is some general information you need to know about this law and
cancellation of mortgage debt.

General Rule for Debt Forgiveness
If a lender forgives some or all of an individual's debts, the general
rule is that the forgiven amount is treated as ordinary income and the
borrower must pay tax on the forgiven amount. Exceptions apply for
bankruptcy, insolvency and certain other situations, including mortgage
debt.

Current Law for Mortgage Debt
(Jan. 1, 2007 through Dec. 31, 2012): A borrower can be excused from
paying tax on forgiven mortgage debt. The debt must be secured by a
principal residence and the total amount of the outstanding obligation may
not exceed the original mortgage amount plus the cost of any improvements.

Does the relief apply only to a sale?
No. The provision has broader application. Lenders might forgive some
portion of mortgage debt in a short sale (when value at sale is less than
the amount owed) or in a foreclosure where the debt is wiped out. In
addition, if a borrower still living in the home is able to make an
arrangement with a lender that reduces the principal balance of a
mortgage, the amount forgiven in that workout will not be taxed.

Can the homeowners in a short sale or foreclosure claim a loss?
No. The loss is considered a personal loss and is, therefore, ineligible
for either capital loss or ordinary loss treatment.

What happens to the seller when mortgage debt is forgiven?
Until January 1, 2013, the homeowner will pay no tax on any forgiven amount.

Does this provision apply to a refinanced mortgage?
Only in limited circumstances. The relief provision can apply to either an
original or a refinanced mortgage. If the mortgage has been refinanced at
any time, the relief is available only up to the amount of the original
debt (plus the cost of any improvements). Tax relief is generally not
available for second mortgages or home-equity lines of credit where the
funds are not used for home improvement. Any amount that is not eligible
for the relief provision will be taxed as ordinary income.

How does the homeowner get the correct information to the IRS?
The lender is required to provide the homeowner and the IRS with a Form
1099 reflecting the amount of the forgiven debt. The borrower/homeowner
must file a Form 982 to reflect the amount forgiven and to show the reason
why the forgiven amount is not taxable. Any taxable portion of forgiven
debt will then be reported on the homeowner's Form 1040 for the tax year
in which the debt was forgiven.

What if a property declines in value but the owner stays in the house?
The provision would not apply. The provision applies only at the time of
sale or other disposition or when there is a workout (reduction of
existing debt) with the lender.

Do all lenders forgive mortgage debt when property values decline or the
home is in foreclosure?
No. Some states have laws that allow a lender to require a repayment
arrangement, particularly if the borrower has other assets. Forgiveness of
debt is always at the lender's discretion.

Linda Goold is the Tax Counsel for National Association of REALTORS®.
Article from RISMedia: http://rismedia.com

Carol Lusidia Morrow, REALTOR® CENTURY 21
Award 7676 Hazard Center Dr.#200 San Diego, CA 92108
(619)368-6382 www.CLMrealestate.com DRE# 01463404

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