If your debt to someone else has been canceled or forgiven, the canceled amount may be taxable. Generally, to the extent that a loan from a lender is not fully satisfied and a lender cancels the unsatisfied debt, you have cancellation of indebtedness income. The Mortgage Debt Relief Act of 2007 generally allows to exclude the income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence.
The Act applies to debt forgiven in years 2007 through 2014. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.
Here is an example. You borrow $20,000 and default on the loan after paying back is $4,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $16,000, which generally is a taxable income.
In the event of a foreclosure, the difference between the outstanding balance of the loan and the fair market value is considered the amount of cancelled debt. If the property was your main home the gain on a short sale could also be excluded from income via the Mortgage Relief Act of 2007 as well. If your lender cancelled part of your mortgage through a loan modification or ‘workout,’ you may be able to exclude that amount from your income. You may also be able to exclude debt discharged as part of the Home Affordable Modification Program (HAMP). On the contrary, the losses from the sale of foreclosure of personal property are not deductible and you will not be able to claim a loss on your tax return.
As we are in the last quarter of 2015, extension of the provisions later and later in the year is creating uncertainty in terms of being unable to project tax liability for those whose debt was forgiven or cancelled. It is still not clear whether Congress will have extender legislation passed.
The following resources are helpful in case if you would like to read more about debt cancellation.
1) Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals) addresses in a single document the tax consequences of cancellation of debt issues.
(2) See the IRS news release IR-2008-17 with additional questions and answers on IRS.gov.
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