According to IRS regulations, when debt is canceled or forgiven by a lender, the amount that has been canceled is considered income for the debtor during tax time and must be reported as income. In light of the recent housing and foreclosure crisis, this regulation would be especially frightening for the thousands of Americans who are going through loan restructuring and modification processes, or having their mortgages canceled due to foreclosure.
However, when the economy took a turn for the worst, and right before the housing bubble burst, Congress passed the Mortgage Forgiveness Debt Relief Act of 2007, which allowed homeowners who were already having financial trouble to avoid having to pay taxes on their forgiven or foreclosed mortgages. In fact, according to that Act, if part or all of your mortgage debt is forgiven in any tax year from 2007 to 2012, you might be able to exclude a substantial amount of that forgiven debt from your taxable income when tax time rolls around.
The debt that qualifies for this must have been incurred for your principle place of residence (not a vacation home), and can include debt that has been canceled through foreclosure or debt from mortgages that were reduced through restructuring or modifying the loan.
From the IRS website, here are a few additional facts about Mortgage Debt Forgiveness.
1. The limit is $1 million for a married person filing a separate return.
2. To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence.
3. Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion.
4. Proceeds of refinanced debt used for other purposes – for example, to pay off credit card debt – do not qualify for the exclusion.