Many people do not realize that if they negotiate with a creditor to reduce the debt they owe, they might be imputed income for the amount of the reduction. In other words, any debt forgiven is considered income and can be reported to the IRS through a 1099 (ie: You borrow $10,000 and default on the loan after paying back $2000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8000, which generally is taxable income to you.).

The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately).

Is Cancellation of Debt income always taxable?

Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:

• Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
• Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
• Insolvency: If you are insolvent when the debt is canceled, some or all of the canceled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
• Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.

Does the Mortgage Forgiveness Debt Relief Act apply to all forgiven or canceled debts?

No. The Act applies only to forgiven or canceled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. This is known as qualified principal residence indebtedness. The maximum amount you can treat as qualified principal residence indebtedness is $2 million or $1 million if married filing separately.

How is the Cancellation of Debt Reported to the IRS?

Any debt forgiven of $600 or more will be reported through Form 1099-C, Cancellation of Debt. The amount of the canceled debt is shown in box 2, and unless you meet one of the exceptions or exclusions, the canceled debt is considered ordinary income.