Debt Forgiveness

Mortgage Debt Cancellation Relief Q&A

General Rule for Debt Forgiveness
If a lender forgives some or all 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 applies through 2025 for certain home mortgage debt that is forgiven. This provision has expired and been reinstated by Congress many times since it was first enacted in 2007. The Further Consolidated Appropriations Act of 2021 extended the exclusion, with some changes, through December 31, 2025.

Under the current law’s temporary provision, a borrower is excused from paying tax on forgiven home mortgage debt (up to $750,000), 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. Before this latest extension, the amount of exclusion could be as high as $2 million.

Example: Assume a family purchased their home for $975,000, with a mortgage of $950,000. 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 $920,000. At the time of the sale, the outstanding balance on their mortgage was $932,000. 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.

A short sale negotiator is trained to negotiate the debt difference with the lender. 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). Sometimes sellers need to still come to the table with money to complete the sale and sometimes the bank forgives the entire amount. It's unknown what the bank will decide until the proper paperwork is submitted and negotiations are underway.

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 exclusion, the forgiven amount is not subject to income tax.

Does this provision apply to a refinanced mortgage?
Only in limited circumstances. The relief provision can apply to either an original or a refinanced mortgage. If the mortgage has been refinanced at any time, the relief is available only up to the amount of the original debt used to acquire the residence (plus the cost of any improvements). Relief is generally not available for second mortgages or home-equity lines of credit where the funds are not used for home improvement.

How does the homeowner get the correct information to the IRS?
Lenders that forgive debt are required to provide the homeowner and the IRS with an information form (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 2021 would provide the 1099 information to the IRS and the homeowner in January 2022 and it would be reflected as appropriate (most likely excluded from income) on the 2021 Form 1040 that is due April 15, 2022.

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 apply unless the lender agrees to reduce the amount of mortgage debt owed. The provision applies 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 next extension was for two years (through December 31, 2016) in the Protecting American Taxpayers from Tax Hikes (PATH) Act of 2015. Then, the measure was extended through December 31, 2017, by the Bipartisan Budget Act of 2018. The next extension was for three years, through December 31, 2020, by the Taxpayer Certainty and Disaster Tax Relief Act of 2019 (which was enacted as part of the Further Consolidated Appropriations Act, 2020). Finally, the exclusion was extended through December 31, 2025, by the Taxpayer Certainty and Disaster Tax Relief Act of 2020, which was enacted as Division EE of the Consolidated Appropriations Act, 2021.

Is Congress likely to extend the provision beyond 2025?
Based on this provision’s history, the chances for further extensions seem positive. However, much can change in the legislative and political environments before the provisions expires again.