Sometimes borrowers find that they are no longer able to make their monthly mortgage payments. This could be due to a dire financial situation (such as a job loss) or because the mortgage terms were automatically modified (which is what occurs with adjustable-rate mortgage loans resulting in higher monthly payments that are now unaffordable. If the borrower defaults on their loan, the mortgage lender has the legal grounds to initiate a foreclosure on the property. Under the Mortgage Debt Relief Act, any debt that is forgiven in association with a foreclosure can be excluded from your income and will not be subject to taxation.
A deed-in-lieu of foreclosure is an alternative to foreclosing for homeowners who can no longer afford to make their mortgage payments. With this option, the delinquent borrower surrenders all interest in the property to the lender (who now takes over the home) in exchange for releasing the borrower from their mortgage debt obligation. A deed-in-lieu of foreclosure satisfies the loan in default and it may be less harmful to your credit score (than traditional foreclosure). This alternative also helps you avoid going through the entire foreclosure process and proceedings. If the mortgage lender decides to forgive the deficiency balance (resulting from the sale of the property) as part of your deed-in-lieu of foreclosure arrangement, the IRS still generally considers the forgiven amount as part of your taxable income. Fortunately, the Mortgage Debt Relief Act allows qualified taxpayers to get an exception from paying tax on debt that is forgiven in relation to a deed-in-lieu of foreclosure. Short sale
A short sale is another alternative to foreclosure that struggling homeowners may consider. With a short sale, the home is sold for less than the balance remaining on the mortgage loan. The lender agrees to accept less than the amount owed on the mortgage loan, and the borrower receives no money from the sale, but avoids having to go through a foreclosure. If the mortgage lender decides to forgive the deficiency balance (resulting from the sale of the property) as part of your short sale arrangement, the IRS still generally considers the forgiven amount as part of your income that is subject to tax. The Mortgage Debt Relief Act permits taxpayers to exclude the amount of forgiven debt from their taxable income. Form 982 for mortgage forgiveness
Use IRS Tax Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness, and Section 1082 Basis Adjustment) to claim the mortgage forgiveness tax break. On this form you can report the exclusion of forgiven debt for your mortgage loan that is associated with principal forgiveness, foreclosure, a deed-in-lieu of foreclosure, or a short sale. Note that you will only need to fill out part of Form 982 because it is also used for other purposes. Complete the appropriate lines and then attach Form 982 to your regular income tax return. For information
For more information about mortgage forgiveness and the 2007 Mortgage Debt Relief Act, please refer to the following documents: