Canceled Mortgage Debt: What Happens at Tax Time?

Some taxpayers who've had mortgage debt cancellation can exclude the forgiven amount from their income for federal tax purposes.

Updated by , Attorney (University of Denver Sturm College of Law)

Homeowners who've had mortgage debt forgiven, like after a foreclosure, loan modification, short sale, or deed in lieu of foreclosure, sometimes owe federal income tax on that mortgage debt cancellation.

To keep financially strapped homeowners from taking a hit at tax time, Congress passed the Mortgage Forgiveness Debt Relief Act in 2007, and I.R.C. § 108(a)(1)(E) was added to the Internal Revenue Code. This law created the "Qualified Principal Residence Indebtedness" (QPRI) exclusion.

Under this exclusion, if part or all of your mortgage debt on your principal residence is forgiven, you might be able to exclude the forgiven debt from your taxable income.

What Is Canceled Mortgage Debt?

Ordinarily, when $600 or more of debt is forgiven or canceled by a creditor, the amount forgiven is considered income for federal tax purposes. When it's clear you won't be repaying the money you received, tax law recognizes the money as income.

Canceled Mortgage Debt Example

For example, say you do a short sale, selling your home for $550,000. But you owe the lender $600,000. As part of the short sale agreement, your lender agrees not to pursue you for the deficiency and issues you an IRS Form 1099-C, Cancellation of Debt, form.

The waived amount might be considered income for tax purposes.

How Is Canceled Mortgage Debt Taxed?

The amount of the forgiven debt is considered income only once it's canceled. So, you must report the forgiven amount on your federal (and perhaps state) tax return and pay taxes on it, just like any other kind of income, unless you qualify for an exception or exclusion.

Who Is Eligible for the Canceled Mortgage Debt Exclusion?

If your lender has forgiven some or all of your mortgage debt, can you get out of paying income tax on that debt using the QPRI exclusion? Here are the key factors that determine if you qualify for the QPRI exclusion.

  • Only mortgage debt forgiven sometime in the calendar years (not tax years) 2007 through 2025 (or after January 1, 2026, if you entered into a written agreement before that date) qualifies.
  • The forgiven debt must have been incurred to purchase, build, or make significant renovations to your principal residence or a refinance of such amounts, not a vacation home or a property you rent out to others. The I.R.S. jargon for this kind of debt is "qualified principal residence indebtedness."
  • Qualifying debt can include mortgages that were reduced through modification or restructuring or mortgage debt that has been canceled through a foreclosure, short sale, or deed in lieu of foreclosure.
  • Proceeds from refinanced debt will qualify for exclusion from income only if those proceeds were used to make significant renovations or improvements to your principal residence—not to make purchases or pay other bills.
  • If your forgiven mortgage debt qualifies, as of December 31, 2020, you can exclude up to $750,000 ($375,000 if married and filing separately). Before this date, taxpayers could exclude $2 million ($1 million if married and filing separately).
  • You can find out the exact amount of mortgage debt forgiven by looking at any paperwork sent by your lender. Specifically, look for a notice called "Form 1099-C: Cancellation of Debt."
  • If your forgiven debt qualifies for this exclusion, even though it will be excluded from your income and you won't need to pay income taxes on it, you still need to report the debt to the Internal Revenue Service (IRS) as part of your tax return.

When Does the QPRI Exclusion Expire?

The QPRI exclusion expires on January 1, 2026. But the exclusion can also apply to debts forgiven as the result of a written agreement entered into before January 1, 2026, even if the actual discharge happens later. (I.R.C. § 108(a)(1)(E)).

Other Exceptions

If you don't qualify for tax relief under the QPRI exclusion, you might qualify for another exception or exclusion.

Cancellation of debt income generally isn't taxable if the debt has been discharged in bankruptcy (before it's forgiven), you're insolvent when the debt is forgiven, the debt is a certain kind of farm debt, or if the property was subject to a nonrecourse debt. (A "recourse debt" is a loan the borrower is personally liable to repay.)

Getting More Information About Cancellation of Mortgage Debt

The IRS has more information about forgiven mortgage debt and instructions for taxpayers at www.irs.gov. Review IRS Publication 4681 on Canceled Debts, Foreclosures, Repossessions, and Abandonments, as well as Topic No. 431 Canceled Debt – Is It Taxable or Not?

Read More Articles

Learn more about tax consequences when a creditor writes off a debt.

Get information about strategies for negotiating with creditors to settle debts.

Talk to a Lawyer

Tax laws are complicated. If you received a 1099-C form indicating your lender forgave all or part of your mortgage debt, or if you're considering completing a loan modification, short sale, or deed in lieu of foreclosure that has tax implications, talk to a tax attorney or tax accountant to get advice specific to your circumstances.

If you have questions about how foreclosure works, need help applying for a loan modification, or want to learn the pros and cons of completing a short sale or deed in lieu of foreclosure, talk to a foreclosure lawyer.

A HUD-approved housing counselor can also provide you with loss mitigation information.

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