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Defaulting on a Debt? Falling Behind On or Abandoning a Mortgage?
Chris W. Strand, MST, CPA/PFS
Principal and Director, High Net Worth Services
The recession has taken a toll on the finances of many Americans, and not just those of limited or moderate means. With continuing job cuts, tightening credit, a down market and falling home values, even affluent families may find it difficult to meet financial obligations.
As many as one in four homeowners has a mortgage that is under water, with a principal balance that exceeds the home's market value―and an increasing number of them are simply walking away. Nearly one in ten homeowners with an FHA loan had missed three or more payments by the end of last year.
According to the National Foundation for Credit Counseling, 34 million Americans also experience difficulty making credit card payments and 18 million have missed at least one payment. Credit card companies are writing off record amounts of consumer debt.
If you or someone you know is struggling to meet mortgage or other financial obligations, you're probably aware of the impact a default can have on personal finances and credit ratings. But you should know that there are also tax consequences from defaulting on or restructuring a mortgage or other debt.
Tax Consequences of Canceled Debt
When you borrow money―whether you borrow from a government agency, a commercial or mortgage lender, a credit card company, or any other source―the proceeds are not considered income for federal tax purposes because you are obligated to repay the proceeds.
However, if your debt is reduced, canceled or forgiven, the amount that you are no longer obligated to repay generally becomes taxable as ordinary income for federal tax purposes. If the amount of the canceled debt is at least $600, the agency or company that canceled the debt is required to report the amount to the IRS (and to you) using Form 1099-C, Cancelation of Debt.
Exceptions and Exclusions
Under current tax law, there are important exceptions and exclusions to the general rule that canceled debt is taxable as ordinary income. They include the following:
 Bankruptcy or Insolvency If your nonbusiness debt is discharged through a Title 11 bankruptcy, the canceled debt is not considered taxable income to you. Likewise, if you are insolvent when your debt is canceled―in other words, the total value of your assets is less than the total amount of your debt―the canceled debt is not treated as taxable income.
Qualified Principal Residence Under the Mortgage Debt Relief Act of 2007, if debt on your principal residence is partially or totally forgiven as a result of foreclosure or mortgage restructuring, you can exclude the amount from your taxable income. However, the debt must be secured by your home, with the proceeds used to buy, build or substantially improve your principal residence. If the debt was incurred in refinancing your home, it qualifies only up to the amount of the principal balance before refinancing.
Further, the debt forgiveness must derive from a change in your financial condition or a decline in your home's value and not from any other circumstance, such as payment for services you provided to your mortgage lender.
This exception only applies to debt forgiven during the period beginning January 1, 2007 and extending through December 31, 2012. The maximum amount excludable is $2 million―or $1 million for married couples filing separate returns.
Nonrecourse Loans If your lender forgives debt related to a nonrecourse loan―one for which the only recourse is to repossess property being financed or used as collateral―you are not required to report cancellation of debt income.
Other Exceptions and Exclusions The law provides for a number of other exceptions and exclusions to the general rule. Certain canceled debt qualifies as an exception if it is specifically excluded from income by law, such as debt canceled by gift or bequest.
Additional exceptions include cancelation of qualified student loans―such as loans that are forgiven after the borrower satisfies requirements regarding post-graduation employment―a qualified purchase price reduction given by a seller, and canceled debt for a cash-basis taxpayer who could otherwise deduct the debt payment, as well as cancelation of qualified farm indebtedness and qualified real property business indebtedness.
Other Tax Consequences
Canceled debt that is excluded from income reduces the tax basis of any property to which it relates. For example, if your mortgage lender restructures your home loan to reduce the principal you owe, the amount of the principal reduction decreases your basis in your home. Canceled debt also reduces any related tax credits or tax losses.
You should also know that if your debt is secured by real or personal property, and your lender takes your property to satisfy some or all of the debt, your property is treated as if it was sold. You may have a gain or loss for tax purposes. Losses resulting from foreclosure or sale of personal property are not deductible for tax purposes.
For More Information
To learn more about the federal tax treatment of canceled debt, you can refer to IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals)
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