Posted on: July 27th, 2012

Time may be running out for homeowners to take advantage of existing legislation that eliminates the requirement to pay income tax on debt that is forgiven in a short sale, foreclosure or loan modification.  The Mortgage Debt Relief Act of 2007, set to expire in December 2012, offers relief of income tax liability on debt forgiven by a lender during tax years 2007-2012.

What is Forgiven Debt?

In general, when a borrower takes out a mortgage to purchase a property and the lender later forgives or cancels a portion of that loan obligation as a result of a loan modification, short sale or foreclosure, the amount forgiven results in taxable income to the borrower. The enactment of the Mortgage Debt Relief Act in 2007 provides relief for homeowners by excluding tax liability on forgiven debt in certain circumstances.

Who Qualifies for the Exclusion Under the Act?

It is a common misconception that all debt forgiven as a result of a loan modification, short sale or foreclosure is exempt from taxation.  This is simply not the case.  In order for a borrower to qualify for exemption under the Act, certain conditions must be met.  First, the property for which the debt is forgiven must qualify as the borrower’s primary residence.  A second home, business or rental property does not qualify for the exemption. Second, the debt must have been used to buy, build or substantially improve the principal residence.  Proceeds from a cash-out refinance used to pay down other debt or purchase a car, etc. do not qualify for the exclusion.  Third, a borrower may exclude up to $2 million in forgiven debt, $1 million if married, but filing separately.

What Does the Future Hold?

In the short term, some believe that we may be in for a spike in the number of homeowner’s attempting to take advantage of the existing tax benefits by attempting to effectuate a short sale or loan modification by the December 31, 2012 deadline.  In the long term, if the exclusion is not extended, we may see the popularity of the short sales and loan modification programs dwindle, as homeowners must take into account the income tax implications of these options.

In March 2012 Representative James McDermott introduced the Homeowner Tax Fairness Act, which if enacted would extend the tax exclusion of the discharge of debt on a principal residence through 2015.  The bill has yet to be signed into law.

Helpful Links and Resources:  Mortgage Debt Forgiveness: 10 Key Points,,,id=254930,00.html,  “Questions and Answers on Home Foreclosure and Debt Cancellation – IRS Publication 4681.

Kari Malone