Generally, the Internal Revenue Service (IRS) treats debt forgiveness by a creditor as taxable income. However, under federal legislation that took effect in 2007, certain home mortgage debt cancellations—such as loan modifications, short sales, or foreclosures—may be exempted from federal taxes. Other exemptions are also available.
- Homeowners considering a loan modification, short sale, or foreclosure should note that the federal tax exclusion under the Mortgage Forgiveness Debt Relief Act of 2007 only applies to mortgage balances on a qualified principal residence and not on second homes, rental real estate, or business properties.
- The maximum amount of forgiven debt eligible under the 2007 law is $2 million for married taxpayers filing jointly and $1 million for single taxpayers.
- The debt reduction only can be for loan amounts used to buy, build, or substantially improve a principal residence, including refinance loans as long as an increase in the total mortgage debt if any is attributable to renovations and capital improvements of the house. However, if refinance proceeds were used for other personal purposes, such as paying off credit card bills, purchasing cars, or investing in stocks, then the mortgage debt attributable to those expenditures is not eligible for tax exclusion under the 2007 law.
- California homeowners who sold their house in a short sale or were foreclosed upon in 2009 still may have to pay state taxes on forgiven mortgage debt. The California legislature did not extend the tax exemption for mortgage debt forgiveness for state taxes. However, lawmakers are working on a bill that would provide the same tax relief on state taxes as the federal government currently offers.