It’s happening all over the place. Homes are being foreclosed on and banks are forgiving loans. Having your loan forgiven can be a lifesaver, but being taxed on that loan forgiveness can be devastating. There are remedies to help ease the tax burden, but make sure you know the facts so that it doesn’t come back to bite you.
If your debt has been cancelled by the bank, you should receive a document called Form 1099C, Cancellation of Debt. This form also goes to the IRS. It must show the amount of debt forgiven and the fair market value of the property that was foreclosed. Once you get a 1099C, make sure that you check it over carefully. If anything is wrong on that form, you need to go back to the bank to have them change it. The two important numbers you’re looking at are the debt forgiven amount (that’s box 2), and the fair market value of the property at the time of foreclosure (box 7). These figures will be extremely important to you, especially if you have credit card debt or college loan money tied up in your mortgage.
The Mortgage Forgiveness Act of 2007 allows you to exclude up to $2 million of debt forgiven on your principal residence. The limit is only $1 million for a married person filing a separate return. You don’t have to be foreclosed on to exclude debt—you may also exclude debt reduced through a mortgage restructuring. This is really important for people doing a workout with their bank.
To qualify for mortgage forgiveness, the debt had to be used to buy, build, or substantially improve your main home and the mortgage had to be secured by the home. For example: let’s say you bought your home for $250,000 back in 2003. You put $50,000 down and financed the other $200,000. The value of your home was going up, and in 2006 when the balance of your loan was $180,000 you refinanced and took out another $50,000 to pay off credit cards. Times have changed and now you have outstanding debt on your home of $230,000 but the value has dropped to $200,000. The bank forecloses and forgives your debt of $230,000. $180,000 can be written off as mortgage forgiveness because that’s the value of what you used to buy the home, but the remainder will still be taxable to you unless you qualify under some different category to abate the taxes. See where the problem is here? If the home is worth $200,000 when your debt is written off, the whole $180,000 that would have been forgiven is already covered by the value of the home, so really the only debt being written off is the other $30,000 remaining after the fair market value of the home is written off. Because that’s not part of the purchasing debt, that $30,000 is fully taxable, unless you can use of the other exclusions.
If you qualify to exclude your mortgage forgiveness from tax, you’ll need to complete Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (what a mouthful) and attach it to your federal tax return. Here’s a link to the form on the IRS website: http://www.irs.gov/pub/irs-pdf/f982.pdf. If 100% of your debt forgiven was for a mortgage used to buy, build or improve, it’s not that hard to do the forms. If you’ve got any other debt included with your mortgage forgiveness, don’t go it alone.
Debt that was forgiven on credit cards, second homes, rental property, car loans, or business property does not qualify for the principal residence exclusion. The debt might still qualify for a tax exclusion based on another category, like insolvency. There are instructions about claiming the insolvency exclusion on the IRS website, but for that you might want to get professional help with that. You can’t just go, “Oh, I couldn’t pay so I was insolvent.” The paperwork is a little more complicated than that and it tends to get looked at pretty carefully by the IRS. To be honest, I’ve had to help a few people who tried filing 982 forms on their own and wound up getting IRS letters. Personally, I think it’s cheaper to get help from the start and do it right than have to pay someone like me later to straighten out a mess with the IRS.