The IRS states that if you owe a debt to someone else and they cancel or forgive that debt, the canceled amount may be taxable. When a lender forgives any amount of the debt owed by the borrower, that borrower could incur a tax liability.
However, there is the Mortgage Debt Relief Act of 2007 that generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.
This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.
Please consult with legal and tax experts for details.
