Understanding Mortgage Forgiveness Debt Relief ACT

By Sean A. Kelly

During my taxation internship in a small audit firm, I have come across accounts where taxes are charged on cancelled or forgiven debts. It seemed like a ludicrous idea, to charge tax on a cancelled debt; after all, where is the income to be charged? As I delved deeper into the subject, I learnt some important facts on debts and tax that may be useful to a lot of people out there, and I’m going to share them here.

For taxpayers in the United States, whenever a debt is cancelled, debt income or cancellation of debt (COD) income occurs. In the US, any income earned by a person is taxable by the Internal Revenue Service (IRS) and the court definition of income is ‘the accession to wealth that is realized, over which the taxpayer has complete dominion’. According to the court, when a debt is freed, there is an accession to wealth – the money that is supposed to pay for debts is now free to be used for anything else – and so that is also potentially taxable.

However, the good news is that under the Mortgage Forgiveness Debt Relief Act 2007, forgiven mortgage debts may be excluded from the taxable income. In general, the Mortgage Forgiveness Debt Relief Act allows homeowners to exclude debts forgiven on their principal residence from taxation. The Act applies to debts that are used to buy or improve your principal residence, and also includes debt incurred to refinance a home; it is, however, not available if the forgiven debt is on a home other than your primary residence. This is called qualified principal residence, and only debts forgiven between the years 2007 and 2010 qualify under this Act. The maximum amount allowed is up to $2 million and $1 million for separate filling.

This may come as another form mortgage debt relief for many taxpayers. Most creditors would not be willing to forgive a debt unless there is no other way out. Usually, this would mean that the debtor is not able to meet the monthly minimum payment, even after going through all kinds of repayment plans or debt reduction strategies. The forgiven debts are also usually no small amount, which means that the debtor probably cannot afford to pay the taxes charged on the forgiven debts. In order to pay those taxes, the debtor might need another loan, which simply starts off another vicious cycle of debt again.

Since the US financial crisis, many people have been having problems with their mortgage debt and it has become an increasingly serious problem. One of the more viable options to clearing debts without filing for bankruptcy is debt settlement, which typically leads to the problem of forgiven debts. If your forgiven debts do not qualify under the Mortgage Forgiveness Debt Relief Act, it is likely that you will be taxed on it. However, you’ll be glad to know that there are other exceptions where debt income is not taxable. These include:

1. Debts that are cancelled insolvency period, where your liabilities exceed the fair market value of your assets,

2. Certain farm debts,

3. Non-recourse loans, where taxpayers lost their properties through foreclosure,

4. Cancelled debts that are intended as gifts,

If your debts are cancelled due to bankruptcy, then they are not taxable either.

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