Updated August 22, 2017
General Rule for Debt Forgiveness
If a lender forgives some or all of an individual’s debts, the general rule is that the forgiven amount is treated as ordinary income and the borrower must pay tax on it. Permanent exceptions apply for bankruptcy and insolvency. Another temporary exception applied through 2016 for home mortgage debt that is forgiven. This provision has now expired but might be reinstated by Congress.
Previous Law for Mortgage Debt (January 1, 2007 through Dec 31, 2016)
Until December 31, 2016, a borrower could be excused from paying tax on forgiven home mortgage debt (up to $2 million), so long as the debt was secured by a principal residence and the total amount of the outstanding mortgage did not exceed the home’s original purchase price plus the cost of improvements.
Example: Assume a family purchased their home for $175,000, with a mortgage of $150,000. Later, they needed to sell the home due to a change in employment. They found that the value of homes in their area had declined and they could sell for only $120,000. At the time of the sale, the outstanding balance on their mortgage was $132,000. Thus, there would not be enough cash at settlement to repay the lender the full balance of the mortgage. If the lender forgave the entire difference between the amount owed and the sales price, the debt forgiven would be $12,000.
Lenders might forgive some portion of mortgage debt in a sale known as a “short sale” (as in the example, when the sales price is less than the amount owed), in foreclosure, or when there is no sale, but the lender agrees to reduce the outstanding balance on a refinanced mortgage.
What happens to the seller when a portion of mortgage debt is forgiven?
Under pre-2007 law, the amount of forgiven mortgage debt (the $12,000 in this example), would have been treated as income, and taxed at ordinary income rates. Thus, the seller, who had experienced a true economic loss, would have been required to pay tax on this “phantom” income, even though no cash has changed hands and even though he has experienced a loss. Under the temporary provision that expired at the end of 2016, the forgiven amount was not subject to income tax.
Did this provision apply to a refinanced mortgage?
Only in limited circumstances. The relief provision could apply to either an original or a refinanced mortgage. If the mortgage has been refinanced at any time, the relief was available only up to the amount of the original debt used to acquire the residence (plus the cost of any improvements). Thus, if the original mortgage was $125,000 and the homeowner later refinanced in a cash-out arrangement for a debt totaling $140,000, the $15,000 cash-out was not eligible for relief if a lender later forgave some amount related to the cash-out. Relief was generally not available for second mortgages or home-equity lines of credit where the funds were not used for home improvement.
How did the homeowner get the correct information to the IRS?
Lenders that forgive debt are required to provide the homeowner and the IRS with a Form 1099-C reflecting the amount of the forgiven debt. The borrower/homeowner must determine (often with a tax advisor) whether the forgiven amount is reported (taxable) or excluded (not taxed) on his/her Form 1040 for the tax year in which the debt was forgiven. For example, a lender that forgave mortgage debt in March 2015 would provide the 1099 information to the IRS and the homeowner in January 2016 and it would be reflected as appropriate on the 2015 Form 1040 that was due April 15, 2016.
Does this provision apply to commercial real estate?
Permanent rules enacted in 1993 can provide relief to debt-burdened commercial real estate and rental properties. The 2007 provision puts commercial/investment property and residential owner-occupied property on somewhat similar footing.
What if a property declines in value, but the owner stays in the house?
The provision would not have applied unless the lender agreed to reduce the amount of mortgage debt owed. The provision applied only at the time of sale or other disposition or when there is a workout (reduction of existing debt) with the lender. No mechanism exists to reflect the loss of value when a property remains in the hands of the underwater borrower and no changes are made to the mortgage balance. Similarly, if the home is sold for a loss, there is no capital loss treatment available for that sale.
Do all lenders forgive mortgage debt when property values decline or in foreclosure?
No. In states with applicable laws, the lender may require a repayment arrangement, particularly if the borrower has other assets.
When did this legislation pass?
A version of the mortgage relief provision passed the House in 1999 and 2000, but was not enacted. The rules of current law were enacted in 2007 as part of H.R. 3648, a bill focused solely on housing issues. The original rules were effective from January 1, 2007 through December 31, 2009. The provision was extended through December 31, 2012 in 2008, and it was again extended through 2013 in the American Taxpayer Relief Act of 2013. Next, the Tax Increase Prevention Act of 2014 extended the provision through the end of 2014. The most recent extension was for two years (through December 31, 2016) in the Protecting American Taxpayers from Tax Hikes (PATH) Act of 2015.
Is Congress likely to extend the provision beyond 2016, and if so, would it be retroactive?
With Congress and the Trump Administration currently focused on trying to enact tax reform, the chance for reinstatement of the temporary provison to exclude forgiven mortgage debt has greatly decreased. In previous years when the temporary provision expired, it was extended on a retroactive basis, almost as a routine matter. But policy-makers have made it clear that this provision, along with a few dozen other so-called “tax extenders” are not going to be automatically extended anymore. Rather, they will be examined in the light of tax reform and many will likely be allowed to expire. However, if Congress did include the provision in a tax reform bill, or if Congress decided that a larger tax reform bill is not possible in the short-term but still wanted to pass small and relatively non-controversial tax relief provisions before the end of the year, any reinstatement of this provision would likely be retroactive to the beginning of 2017.