Forgiven Mortgage Debt Can Be Excluded From Taxable Income

A new law affects up to $2 million forgiven by the lender in 2007, 2008 or 2009

Forgiveness of debt means a bank or lender forgoes repayment of principal and/or interest that a borrower owes. Forgiven or discharged debt is typically considered ordinary income that is taxable.

But a new law, the Mortgage Forgiveness Debt Relief Act of 2007, now gives qualified taxpayers a three-year window to exclude discharged mortgage debt from their taxable income. In other words, if you find yourself doing a short sale on your principal residence, you are entitled to a reprieve from the tax liability.

To qualify:

  • The debt must be discharged between January 1, 2007, and January 1, 2010.
  • The amount of debt that can be excluded is limited to $2 million.
  • The debt canceled must be a loan that was used to acquire, construct or substantially improve a property.
  • The property must be the borrower's principal residence under the tax code, meaning the borrower must have lived in the home for at least two of the previous five years.
  • Forgiveness of debt on vacation homes, second homes and investment property does not qualify.

EXAMPLE: If you bought a principal residence for $450,000 with a $400,000 loan and you sold the home in a short sale for $300,000, the lender discharged $100,000 in debt. You can exclude that amount.

NOTE: For debt forgiven on a cash-out refinance or home equity loan, only the amount borrowed to build, buy or improve the home can be excluded. Any money used for other purposes such as vacations, tuition or paying off credit card debt does not qualify.

Lenders are required to report forgiveness of debt to the Internal Revenue Service. Consult your tax advisor for more information.

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