Mortgage Forgiveness Debt Relief Act

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When a debt you owe is cancelled or forgiven, the cancelled amount may be considered taxable income. This includes mortgage debt that is forgiven. When you borrowed the money, you were not required to report the loan proceeds as income because you had to repay the lender. If that obligation is subsequently forgiven, the amount of the cancelled debt is usually considered income because you no longer have to pay it back. This has the potential to be a significant tax burden if you have had mortgage debt forgiven through mortgage restructuring such as a loan modification or short sale or in connection with a foreclosure.

Fortunately, in 2007 Congress enacted the Mortgage Forgiveness Debt Relief Act (“MFDRA”) to address this problem. The MFDRA allows taxpayers to exclude income from the discharge of debt on their principal residence.  The MFDRA was originally set to expire at the end of 2012, but was extended by the American Taxpayer Relief Act until December 31, 2013. The MFDRA allows up to $2 million of forgiven debt to be excluded from taxable income ($1 million if married filing separately).

To qualify for the exclusion, the forgiven debt must have been used to purchase, build, or improve your principal residence and must be secured by that residence. Proceeds from refinancing that are used to substantially improve your principal residence also qualify under the MFDRA.

The MFDRA does not apply to refinanced debt proceeds that are used for purposes such as paying off credit cards or other debts. The exclusion also does not apply if the discharged debt is in return for services performed for the lender or any other reason not directly related to a decline in the property’s value or the borrower’s financial condition. Moreover, cancelled debt on second homes, investment property, or business property does not qualify under the MFDRA.

If you have debt of $600 or more that is cancelled or forgiven, you will generally receive a year-end Form 1099-C (Cancellation of Debt) from your lender. If the forgiven debt is excluded from income, you still must report the amount of the forgiven debt by filing Form 982 with your tax return.

Even if a cancelled debt does not qualify for the MFDRA exclusion, there may be other exceptions available.  These may include debts discharged through bankruptcy, certain farms debts, or non-recourse loans.

You can find more information about the MFDRA and other exceptions in IRS Publication 4681 and IR-2008-17. If you would like to discuss your situation with one of our attorneys, please contact us at (248) 457-6000.