May 14, 2021
8 MINUTE READ
For most people, getting your debts forgiven and canceled is cause for a huge sigh of relief. No matter how you fell into debt, be it from restructuring or foreclosure, debt forgiveness signals a new beginning, one where you can finally get your finances back on track.
However, debt forgiveness comes with one minor hiccup. Because the IRS views canceled debt as income, it now becomes taxable when you file your annual returns. Consequently, you’ll owe more in taxes, which can hinder your financial recovery.
Fortunately, the government has established debt relief measures to help taxpayers get deal with this situation. This article will discuss some of these policies so you can determine your best plan of action when deciding how to get mortgage debt relief forgiveness.
Usually, when your debt gets canceled, either through debt relief or home loan forgiveness programs, you’ll need to add that debt to your taxable income. Why so? Let us explain.
When you take out a loan, the IRS doesn’t treat that cash influx as income because you’ll need to repay that loan in the future. However, when you remove that financial obligation of repayment, a canceled debt suddenly becomes a taxable asset.
Once a bank or lender cancels your debt, they will send you Form 1099-C (also known as a Cancellation of Debt Form). You file this form together with your federal tax return, essentially informing the IRS that you have canceled debt.
Of course, this means that you’ll end up paying more taxes (at potentially a higher tax rate), which may diminish the financial breathing room you received from canceled debt.
Fortunately, you can find ways around this rule, thanks to the Mortgage Forgiveness Debt Relief Act of 2007. The Mortgage Debt Relief Act is a way for homeowners to avoid paying taxes on forgiven mortgages.
The vast majority of canceled mortgage debt is covered in the Mortgage Forgiveness Debt Relief Act. Short sale, foreclosures, and bankruptcy are some examples. You can also include forgiven debt used for refinancing, such as the restructuring offered by the Obama Mortgage Relief Act. And while people usually use this home mortgage debt relief act to exclude mortgages used to finance a house, it can even cover forgiven loans used for renovation work.
When the act was first introduced in 2007, it provided a relief period of only three years, covering debts up to 2010. After that time, the debt would become taxable again.
Fortunately, the government has renewed the homeowners’ relief act five times, extending the tax-free benefit’s expiration date.
The act was recently extended with the Consolidated Appropriations Act (CAA), signed into law on December 27, 2020. This extension is part of the larger Coronavirus Response and Relief Supplemental Appropriations Act of 2021. It serves as a stimulus, providing relief for individuals and businesses affected by the pandemic.
The CAA extension applies to all forgiven debt before January 1, 2021, including debt relief that should’ve expired in 2018 and 2019. In addition, the coverage extends to 2025. However, the maximum excluded debt has been reduced from two million dollars to only $750,000.
One way to work around taxed debt forgiveness is the Qualified Principal Residence Indebtedness (QPRI) exclusion of the Mortgage Forgiveness Debt Relief Act. To qualify for the QPRI exclusion, you’ll need to align with the eligibility rules, which are pretty straightforward.
First, debt exemption under the act is only applicable to mortgages and loans that use your primary residence as collateral. You must have lived in the house for at least two years within five years before the foreclosure. Second homes, vacation houses, or rental properties cannot be included as an exception.
Second, the debt must only be used for buying, improving, or refinancing your home. If you used part or all of the funds to pay off something else, that debt might not qualify for QPRI exclusion.
If you qualify, you can exclude up to two million dollars in mortgage payments per year, with some exceptions. One is when you’re married, but you’re filing your returns separately from your wife. In that case, the exclusion limit is one million. The other exception is when you used the debt to refinance your home. Here, you can only exclude a debt amount not exceeding the balance of the original loan.
To claim QPRI exclusion, you need to fill out Form 982 (also known as the Reduction of Tax Attributes Due to Discharge of Indebtedness Form). This informs the IRS of which canceled debt you would like to exclude from your taxable income.
When you default on a mortgage, the lender will foreclose your property to recoup his or her losses. If, after selling your home, you still have an outstanding balance, the lender can still go after you for repayment, either by seizing your other assets or garnishing your wages.
In a non-recourse loan, however, the lender can’t do that. They can still foreclose your home, but any remaining balance after that is forgiven. The canceled debt is also excluded from your tax return.
Those who work or earn from farming operations can get a tax exclusion for their canceled debts. The only requirement is that your loan lender is a conventional lender. (Typically, this is either an agency or an individual). You must also have sourced more than 50% of your income from farming over the past three years.
Can’t meet the Mortgage Forgiveness Debt Relief Act qualifications? You’ll be happy to learn there are other ways to exclude forgiven home loans from your taxable income. Here are a few options:
Bankruptcy or foreclosure, although the worst-case scenario for many, does offer a small measure of relief. When you file bankruptcy or foreclosure, canceled debt is automatically tax-free, and you don’t need to include it in your annual return.
However, if the lender seizes your property to cover your debt, it’s considered a sale. Technically, you’re selling your property (albeit unwillingly) to have the funds to pay back the lender.
Additionally, there are two types of bankruptcy for individuals—the discharge of debts and the payment plan. Chapter 7 of the Bankruptcy Code is for the discharge of debts, which is the traditional bankruptcy
Therefore, you might need to declare the proceeds as capital gains. If your gains exceed $250,000, you have to file that as a taxable amount in your tax return under Capital Gains and Losses.
When your total liabilities exceed your total assets, insolvency qualifies you to exclude all or part of your canceled debt in your tax return. The process of insolvency may require you to liquidate your assets so that you can fulfill your financial obligations. However, debt exclusion for insolvents only applies if your debts exceed your assets’ total market value.
You can exclude debt as long as you don’t exceed your insolvency amount. For example, if you have a debt of $300,000 and have assets of $250,000, you are $50,000 insolvent. You can, therefore, only exclude up to $50,000 of your debts in your tax return.
Alternatively, you can also look into other areas besides your mortgage to lower your overall tax liability.
For example, monetary gifts and inheritances usually are non-taxable. You can also exclude some canceled debts, such as student loans. Finally, any debt that results in a deduction once paid is also counted as a non-taxable item.
To illustrate everything we’ve discussed so far, let’s give an example. Say you’ve been living in your house for the past two years. It’s now worth $250,000, but you originally bought it for $220,000. Unfortunately, you’re unable to pay back your financial obligations, including the remaining $270,000 mortgage on your house.
You’re now insolvent, with assets (including your home) totaling $300,000 and liabilities at $320,000. Naturally, the lender forecloses your house and recovers the $250,000 to partially cover your mortgage. However, when figuring gain from the foreclosure, you may still owe the lender $20,000.
Note that, in this example, you made a capital gain of $30,000 from the foreclosure (the current market value of $250,000 minus the purchase price of $220,000). But because your gain didn’t exceed $250,000 and you lived in the house for the past five years before foreclosure, the income is tax-free.
But what about your canceled mortgage? Do you need to include that as your taxable income? Remember, you’re currently insolvent for $20,000 ($320,000 liabilities minus $300,000 assets). Because of this, you can exclude up to $20,000 in forgiven debt, making your canceled mortgage tax-free.
We know tax exclusion and QPRI laws can be tricky. That said, we hope we’ve cleared up a few of your questions. Even if you don’t qualify for one exemption, you might be eligible for another. In order to pay fewer taxes on your mortgage debt relief, you need to be knowledgeable about these exceptions.
With that in mind, the best strategy is to talk to someone with expertise in mortgage and taxes, like our Reali agents. We’ll help you sort through your concerns and help you decide what solution is best for your situation. We can also help you with home loan refinancing as well as traditional home loans. Contact us today!