In 2007, President George W. Bush signed the Mortgage Forgiveness Debt Relief Act into law. This act lets people exclude the income that they have received from the cancellation of debt through foreclosure or mortgage restructuring. The law was originally set to expire on Dec. 31, 2014, but President Barack Obama signed an extension of the law through 2016, making the relief available to taxpayers on their upcoming returns.

Understanding Cancellation of Debt

Normally, people who have portions of their debt canceled because of defaulting on loans have to report the amount that is canceled as other income on their tax returns. There are some exceptions to this rule, including:

  • Debt discharged in bankruptcy
  • Non-recourse loans
  • Farm debts

Prior to 2007, people had to report the forgiven or canceled debt from their mortgages when their lenders foreclosed on their homes or forgave a portion of the debt through mortgage restructuring or short sales. The Mortgage Forgiveness Debt Relief Act allows people to avoid reporting the gain from canceled mortgage debt if certain circumstances apply.

Why canceled debt is treated as income

When people have debts balances canceled by creditors, the IRS treats the balance that the people do not have to pay as taxable income for recourse loans. When a person has a debt canceled, the creditor will send him or her a 1099-C form notifying the person of the amount that he or she needs to report on his or her tax return. Creditors also send a copy of those forms to the IRS so that the IRS knows that the debtors have canceled debts that they should report on their returns. There are certain types of canceled debts that do not have to be reported as income, however. For example, people who work for specific durations of time in certain public service jobs may have the balance of their student loans canceled at the end of the requisite number of years, and the amounts that are canceled are not considered to be taxable income.

Foreclosures and relief from reporting the forgiven balances as taxable income

According to the IRS, the law allows people whose homes have been foreclosed to exclude certain amounts from their income reporting requirements as long as certain conditions are met. A person must have lived in the home as his or her primary residence in two out of the last five years before the foreclosure occurred. The home cannot have been a vacation property or an investment home. A single taxpayer may exclude up to $250,000 of the amount that he or she does not have to pay because of a foreclosure. Married people who file joint tax returns may exclude up to $500,000. If the amount exceeds the exclusion, then the taxpayer reports the portion that is taxable as other income on his or her income tax return.

The Mortgage Forgiveness Debt Relief Act can help people to save substantial amounts of taxes that they would otherwise have to pay. If a person has questions about whether or not he or she may be eligible to exclude gains from mortgage restructuring, short sales or foreclosures, he or she may want to talk to his or her accountant.