What You Need to Know About Taxes and the Mortgage Debt Relief Act of 2007

According to Time Magazine, bankruptcy filings are up 35% from the year before. Many people have found relief in short sales and debt forgiveness, but this can lead to concerns about the tax implications. Not to worry, Uncle Sam has your back when it comes to default debt resolution.

How Forgiven Debt Affects Your Income Taxes

A Supreme Court ruling in 1931 established a precedent for borrowers’ obligations to pay tax on cancelled debt, just as if it were regular income. The decision was reaffirmed in 2005 on the basis that the taxpayer realizes an increase in income when debt is forgiven. You had more money in your pocket and Uncle Sam wanted his cut, but that has changed.

2007 Mortgage Debt Relief Act

But when the economy turned sour, the government came to the rescue with the Mortgage Debt Relief Act of 2007. Normally, homeowners, credit card holders and other borrowers would be required to pay tax on any negotiations they made resulting in forgiven debt. The Act ensures that taxpayers in financial trouble are excluded from paying taxes on debt they could not afford to pay back.

Before the Debt Relief Act, the IRS would only exclude debts discharged in bankruptcy or those debts forgiven to insolvent persons. There were some other small exceptions for other kinds of forgiven debt. With the new law, the forgiven debt can be excluded from income as long as certain criteria are met. Taxpayers should look to IRS Publication 4681 to get all the details and be sure they fully understand the law and how far it goes to relieve the tax burden. You can read the form yourself by going to http://www.irs.gov/pub/irs-pdf/p4681.pdf.

Types of Forgiven Debt Excluded

The Mortgage Debt Relief Act applies to, “Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure,” thereby changing the way the IRS looks at this type of income. While reporting requirements remain unchanged, the IRS’s response to the added income is much kinder than in the past.

The Act keeps the forgiveness provision in place until 2012 and may be extended longer if needed. Taxpayers are allowed to exclude as much as $2 million of forgiven debt, or $1 million if it is a married couple filing taxes separately. However, the exclusion does not apply if the forgiveness did not come about because of declining home value or taxpayer financial condition. Basically, you had to be caught up in the housing financial crisis to qualify.

It is helpful to understand some of the IRS terms related to debt forgiveness and the Act. Here are some explanations to simplify things for you:

IRS Terms Related to the Mortgage Debt Relief Act of 2007

• The IRS calls forgiven debt, “cancelled debt.” Any time that you borrow money and then are forgiven the obligation to pay any of it back, then you have a cancelled debt.  The amount you don’t have to pay back is considered income by the IRS. The lender is required by law to report all cancelled debt on Form 1099-C and mail you a copy of the form. The taxpayer is then required to report the cancelled debt as income, under Form 982. 

• As noted before, there were situations where cancelled debt was not taxable, even before the Mortgage Debt Relief Act. They included debt from insolvency and debt discharged under a bankruptcy filing. With the act, debts from your qualified principal residence can also be excluded from taxation. 

• “Insolvency” is a complicated word for a simple concept. Insolvency simply means that your debts out number your assets, or the value of what you own, plus what you earn is lower than the value of your debts. 

• “Assets” is the term for anything you own. It includes your house, your cars, your personal property and investments. Anything you own with a monetary value is an asset.

• “Exclusion of income” is a term for cancelled debt that cannot be taxed because of the enactment of the Mortgage Forgiveness Debt Relief Act.

• Your “Qualified Principal Residence Indebtedness” is the debt you own on your house, or those debts you acquired to make substantial improvements or to refinance your home.

 

You will not get a 1099-C from the IRS if you were forgiven debt under bankruptcy. But if you had other debt forgiveness, expect to receive the form. Remember to look for it and hold onto it for tax filing purposes. You will not be taxed on cancelled debt if it falls under the Mortgage Debt Relief Act of 2007 or if you were insolvent.