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Mortgage Forgiveness May Be for You

By Elizabeth Rosen

NEW YORK ( IRS.com) -- The current housing market is full of foreclosed homes and properties that have plummeted in value. In fact, it has been reported that the real estate market has a negative equity gap of about $3.7 trillion, with millions of homeowners underwater on their mortgage loans. The good news is that if you are a struggling homeowner, there may be some relief in sight.

If you owe a debt (such as a mortgage loan) and the lender cancels or forgives part of that debt, the discharged amount (which you no longer owe) may still be taxable according to the IRS. Under the Internal Revenue Code, all types of forgiven debt are still treated as income and subject to taxes.

Mortgage forgiveness through the Mortgage Debt Relief Act of 2007
Enter the 2007 Mortgage Debt Relief Act, which was recently extended to be effective until the end of this year (Dec. 31, 2013). This bill allows taxpayers to exclude income (on their tax returns) from the discharged debt on their principal residence. This can include debt that is reduced by mortgage restructuring as well as debt that is forgiven relating to a foreclosure. If the Mortgage Debt Relief Act had expired, any amount of cancelled debt would be considered taxable income for IRS purposes.

The Mortgage Debt Relief Act applies to the following:

  • Homeowners who are granted principal forgiveness on their mortgage loan
  • Homeowners who do a short sale on their home
  • Homeowners who do a deed-in-lieu of foreclosure on their home
  • Homeowners who have lost their home to foreclosure, or are in the process of foreclosure

If you are looking for mortgage forgiveness, you now have less than 12 months to take advantage of this tax relief. And while it may seem like you have a lot of time between now and December, keep in mind that short sales can take up to six months (or more) to complete. A loan modification or a deed-in-lieu of foreclosure can take at least 3 months to finalize, and a foreclosure can take up to a year to complete.

You may be able to exclude up to $2 million of forgiven debt from your taxable income (or up to $1 million if you are married filing separately). Note that this exclusion does not apply to debt that is cancelled for any reason that is not directly associated with the homeowner’s financial situation or a drop in the home’s value.

The Mortgage Debt Relief Act affects four main types of situations:

  • Principal forgiveness
  • Foreclosure
  • Deeds-in-lieu of foreclosure
  • Short sale

Principal forgiveness
In certain cases, the mortgage lender may decide to cancel or forgive part of your debt. This can provide helpful financial relief for struggling homeowners who may no longer have to default on their mortgage loan. With the Mortgage Debt Relief Act, any debt that has been forgiven by your mortgage lender can be excluded from your income and will not be subject to taxation by the IRS. This means that you will not have to pay taxes on debt that you technically no longer owe.

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