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Effects of the sub-prime mortgage debacle are no doubt being felt by all. Especially desperate are those who purchased dream castles during 2005, 2006 and 2007 and are now among the largest group upside down to their mortgage debt and facing foreclosure or abandonment. This issue updates and expands on my previous discussion of mortgage forgiveness of a personal residence appearing in the May 8, 2008 issue. The relief granted by Congress to distressed homeowners who are released from part or all of mortgage debt obligations presents complex and tricky tax law issues that are best handled with the assistance of a lawyer experienced in tax matters.

The Mortgage Forgiveness Debt Relief Act of 2007 (Act) provides tax relief to defaulting homeowners who might otherwise owe income tax on qualifying mortgage obligations forgiven in 2007 through 2009. The Emergency Economic Stabilization act of 2008 extended that relief through 2012.

A lender that is paid less than the full principal owed on a mortgage often decides not to personally pursue the borrower for the deficiency i.e., the amount by which the amount of the mortgage debt obligation exceeds the value of the foreclosed property. In that case the lender is required to file Form 1099-C informing IRS and the borrower of the cancelled portion of the debt. The amount of cancelled debt is taxed at the higher ordinary income tax rates (not as a capital gain) unless certain narrow exceptions or escape hatches are available.


Many logically ask: “Why am I taxed on a debt I cannot afford to pay when I’ve received no funds and have lost my home?” The answer is not comforting: the income tax applies to all income from whatever source derived. Income means an economic benefit received or constructively received, whether in cash or property or in some other form not constituting a gift. When you receive loan proceeds there is no immediate economic benefit because you have an equal obligation to repay the loan. When a debt you owe is cancelled, however, the liabilities on your financial balance sheet decrease and your financial net worth increases by the same amount. An insolvent taxpayer, on the other hand, may exclude cancelled debt from income because, unless he or she is made solvent by the cancellation, no increase in net worth occurs and, in a financial sense, no economic benefit is derived. Of course not being hounded by a creditor or collection agent is a benefit but not one that is counted for income tax purposes. Bankruptcy discharges also escape taxation.


Another exception to taxability is contained in the Act and extension and makes nontaxable certain debt forgiven on a qualified principal residence (QPR) during 2007, 2008 and 2009, with certain limitations as follows:

1. The residence must be your qualified principal residence which means it must have been owned and used as your principal residence for 2 of the 5 years before the forgiveness.

2. The relief applies to one residence only, the one where you live most of the year. Thus, vacation home debt is ineligible for this relief.

3. The debt must be secured by a QPR and must not exceed $2,000,000 ($1,000,000 on a MFS).

4. The debt must have been incurred to purchase, build or substantially improve a QPR or refinance a loan used for such purposes up to the original loan amount.

5. The debt can include a home equity line up to $100,000 ($50,000 on a MFS return) or the FMV of the residence, subject to the overall $2 million/ $1 million limit.

6. The amount excluded from income reduces the tax basis of the property (as in the case of the insolvency or bankruptcy exception) and Form 982 must be filed by the borrower for the year of debt cancellation.

7. The relief is not available for credit card or auto loan debt.


The above rules apply only to the amount of cancellation of debt income. In addition to having cancellation of debt income, a homeowner, adding insult to injury, may realize capital gain or loss on the abandonment, surrender, short sale, foreclosure or deed in lieu of foreclosure with regard to his or her home. For a personal residence the loss is never allowed as an offset to other capital gains or as a deduction against other ordinary income like wages. The gain is not taxable, however, only up to the amount of one’s personal residence exclusion under IRC Section 121 ($500,000 for joint filers/ $250,000 for single filers). Gains exceeding the exclusion amounts are treated like any other capital gain (i.e. netted against losses with the excess, if any, taxed at 15% for most filers). This event may be not so unusual for a single person living in an expensive home purchased and refinanced with a jumbo mortgage during the height of the real estate bubble. For example a home purchased in 1980 for $400,000, refinanced in 2006 for $900,000 and cashed-out. In 2009, the home is deeded to the lender in lieu of foreclosure when the home is worth $800,000 and the mortgage balance is $875,000. There is a gain realized on the exchange of the home for the debt of $400,000 of which $150,000 is taxed as a long term capital gain (after applying $250,000 home sale exclusion). There is also forgiveness of debt income in the amount of $75,000 (excess of loan balance over value of property taken back by lender) which, to the extent not from acquisition indebtedness would be taxable as ordinary income.


1. There is accrued interest on the loan, especially on a home equity loan, that was not used to improve the residence (a cash-out).

2. There is a foreclosure sale of short sale with expenses incurred in connection with the transaction that may or may not be added to the loan balance or sales proceeds allocated to late fees or interest.

3. The home has been both a principal residence and vacation home.

4. One spouse has left the home.

5. A spouse is insolvent immediately after the forgiveness of non-qualifying debt.

6. There is home equity debt and total debt exceeds the fair market value of the home.

7. The home is sold at a gain following debt forgiveness.

8. The home is sold at a loss following debt forgiveness in the same year.

9. The lender participates in the sale of a home at a gain.

10. A single umbrella debt encumbers two residences in which spouses reside separately.

11. Spouses are to file MFS returns following a forgiveness or foreclosure sale.

12. There is disagreement about the value of the property at the time of debt relief, specifically, whether the appraisal, when there is no sale, should include as comparables foreclosure sales occurring in the surrounding area that many argue are distress sales that should not enter into fair market value appraisals. A higher value would shift more to gain and reduce the cancellation portion of the mortgage default and surrender.

13. There exists a genuine dispute regarding the amount of the mortgage obligation lawfully owed. Disputes may arise over questions such as: How interest accruals were calculated? How mortgage rate adjustments were calculated? How payments were applied? What expenses of the lender were added to the unpaid principal balance? What legal defects, if any, in the mortgage documents or missing documents might negate the borrower’s obligation to pay?

14. The home is sold or surrendered at a loss and was used partially for investment or business purposes.


In addition to the above considerations, homeowners facing foreclosure should consider how these alternatives will affect information in credit bureau files and impact FICO credit scores. Astutely structuring the resolution with a lender may make it easier to later remove negative information from credit bureau files under the Fair Credit Reporting Act.

© 2009 by Robert S. Steinberg, Esquire, Miami Florida
Articles and consultations authored by attorney reflect the state of law as of the date of their writing. The laws change daily. Users of this site are advised to consult attorney regarding their situation.
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