Canceled Mortgage Debt: What Happens at Tax Time?

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 canceled debt come tax time. That's because, ordinarily, when $600 or more of debt is forgiven or canceled by a creditor, the amount that has been 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.

The amount of the forgiven debt is considered income only once it's canceled, not when you first borrowed the money. So, you must report the forgiven amount on your tax return and pay taxes on it, just like any other kind of income, unless you qualify for an exception or exclusion.

To keep financially strapped homeowners from taking a second 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, creating 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.

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)).

Eligibility for the QPRI Exclusion

If some or all of your mortgage debt has been forgiven by your lender, will you be able to get out of paying income tax on that forgiven debt using the QPRI exclusion? Here are the key factors to remember.

• 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 you're married and filing separately).
• You can find out the exact amount of mortgage debt that's been 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 the debt will be excluded from your income and you won't need to pay income taxes on it, you still need to report the forgiven debt to the I.R.S. as part of your tax return.

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

Other Exceptions

If you don't qualify for tax relief under the QPRI exclusion, you might qualify for another kind of exception or exclusion. For instance, 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 that the borrower is personally liable to repay.)

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.