With the collapse of the economy and crash in the real estate market, more and more homeowners are finding that their home is “underwater” in the sense that the value of the their character is worth considerably less than the mortgage or mortgages that are owed on the character.
Because of the economic conditions our country is laboring under, many homeowners are simply unable to continue to debt service their existing mortgage. For those homeowners a foreclosure, short sale, deed in lieu or for the lucky ones a negotiated alteration of the existing loan balance are but some of the many alternatives.
Debt reduced by a mortgage loan alteration, short sale or foreclosure will often consequence in the issuance by the lender of an IRS Form 1099-C, Cancellation of Debt. Under the IRS Code, if you borrow money from a lender who later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes. This is because. when you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is afterward forgiven, the amount you received as loan proceeds is reportable as income because you no longer have an obligation to repay the lender.
There are some shared exceptions to the general rule that cancellation of debt is taxable as income. The most often used exceptions are the bankruptcy and insolvency exceptions.
The bankruptcy exception provides that debts discharged by bankruptcy are not considered taxable income. consequently if you lose your home by foreclosure, go into into a alteration of principal or short sale the home and then file for Chapter 7 bankruptcy, you will not be unprotected to the requirement that your cancelled debt be included as income.
A second related exception is the insolvency exception. Much like the bankruptcy exception, if you are insolvent when the debt is cancelled some or all of the cancelled debt may not be taxable. You are considered insolvent under this exception when your total debts are more than the fair market value of your total assets.
Because of the pervasiveness of this problem of cancellation of debt occasioned by the recession and collapse in the real estate market, Congress enacted the Mortgage Forgiveness Debt Relief Act of 2007. This enactment generally allows taxpayers to exclude income from the release of debt on their principal residence. Debt reduced by mortgage restructuring, in addition as mortgage debt forgiven in connection with a foreclosure, qualify for this relief.