Tax Guide

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Cancelled Debt, Foreclosure, and Short Sales

Owning a home is a major financial obligation, and sometimes it becomes a little too much. Foreclosures, short sales, and cancelled mortgage debt can be confusing and overwhelming. Here are the differences, and how they can affect you.

First, if your home is foreclosed or you voluntarily give up the property, the remaining balance on the mortgage debt is considered a sale by the IRS. If you sell your home for less than what is due on the mortgage, you are considered “underwater” and it's called a short sale.

So what’s cancelled debt? Cancelled debt is the difference between your home’s current fair market value and what you owe on your mortgage. It can be an oxymoron, because even though the debt was supposed to be cancelled, the IRS can see it as taxable income, which can mean higher tax liability for you.

Foreclosure

This is where the mortgage holder repossesses the home due to the homeowner’s failure to keep up with the mortgage payments. Though this process normally takes several months of nonpayment to begin, each mortgage and lender is different.

As an alternative to getting foreclosed on, you may opt to voluntarily return the home to the lender. This process simply means you sign the property back over to the mortgage holder.

Fact: While returning a home and a foreclosure both affect your credit, returning a home will not leave a foreclosure on your credit report, which will stay there for up to seven years.

However the home gets back in the hands of the lender, the IRS considers that a sale happened. You must calculate whether you took a gain or loss. If you took a loss – the debt exceeds fair market value – you have a cancelled debt.

Short Sale

If you owe more on your home than it's worth now, your home is considered “underwater,” sometimes euphemistically called “negative equity.” If you sell your home for less than your remaining mortgage balance, you have cancelled debt.

If you're facing foreclosure, you may qualify for a short sale of your home. Though not ideal, it's still better than a foreclosure.

Cancelled Mortgage Debt

Restructuring your mortgage to reduce the principal on the loan requires you to report the cancelled debt as taxable income. If you work out a lower mortgage amount with the lender, the difference in amounts is cancelled debt and is thus taxable income. Agreeing to pay off the mortgage early for a reduced mortgage amount – a “discount” – also creates cancelled debt.

If you have a cancelled debt from foreclosure, restructuring, or a short sale, some exemptions allow the cancelled debt to become nontaxable. If you meet one of the following minimum requirements, you may exclude the cancelled debt:

  • You qualify for the Mortgage Forgiveness Debt Relief Act of 2007.
  • You file for bankruptcy and your debts are discharged and not considerable taxable income.
  • If you’re insolvent – unable to pay your debts – when the debt is cancelled, some or all the cancelled debt may not be taxable to you.
  • The cancelled debt may not be taxable if you incurred the debt directly in the operation of a farm, the past three years’ income has been from farming, and a qualified lending agency or person owns the loan.
  • You have a non-recourse loan and the only way to remedy the default is the repossession of the property financed or used as collateral.

Entering Cancelled Debt on Your Taxes

If you have cancelled debt, you'll receive a Form 1099-C from the lender. To report that, just fill out the Form 1099-C screen on your 1040.com return.

If one of the exemptions above applies to you, select at the top of the 1099-C screen that the debt is for the Form 982 screen, and also fill out that screen.