Thursday, May 13, 2010

The Mortgage Forgiveness Debt Relief Act and Debt Cancellation

There are many people wondering, if they owe a debt to someone and that person cancels or forgives the debt, is the canceled amount taxable as income next year? The answer is: it depends on the type of debt canceled. Generally, if a debt for which you are personally liable is forgiven or canceled, other than a gift, you must include the amount in your income. However, there are exceptions.

According to the IRS, 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.
  • Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your canceled debt is generally not considered taxable income.
  • 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.
Due to the current housing market, I am sure the exclusion of qualified principal residence debt forgiveness from taxable income is a sigh of relief for many. The Mortgage Debt Relief Act of 2007 generally will allow taxpayers to exclude this discharge of debt on their principal residence. Mortgage debt through foreclosure or debt reduced through restructuring will not be taxable for the calendar years 2007 through 2012. The maximum amount of qualified primary residence debt is $2million ($1 million if married filing separately).

For more information regarding debt forgiveness you may want to visit the IRS’s website or talk to a qualified tax professional.

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