If you recently went through a mortgage modification or the bank forgave a portion of your delinquent loan, good news is headed your way. Prior to 2007, if the bank forgave a portion of your loan, you would normally pay taxes on this amount as income. However, thanks to The Mortgage Forgiveness Debt Relief Act of 2007, your forgiveness or modification is most likely tax free.
To determine whether you owe taxes, you should of course consult a professional, but as a general rule, if you had debt reduced on your mortgage loan through mortgage restructuring, deferment, forbearance, or any other mortgage loan forgiveness program used in conjunction with potential foreclosure, your tax liability is most likely zero. However, as with most tax questions, there are some exceptions.
To receive the debt relief tax free, the residence must be your primary residence. If you do not currently live in the home, you may not qualify for the tax free exclusion. This is especially true if the property is used as rental property or a vacation home.
The Mortgage Forgiveness Debt Relief Act also limits the amount that can be forgiven tax free. The limit is two million unless you are married filing separately, and then you only qualify for 1 million in tax free debt forgiveness.
Foreclosure/Value Decline Only
The tax free debt forgiveness is limited to debt forgiven as a result of foreclosure or the decline in the property's value through no fault of the homeowner. In other words, had the debt not been forgiven, you would have faced foreclosure. The IRS notes that the exclusion doesn't 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.
The debt forgiveness will also reduce your basis in your home. What this means is that some day if you sell your home, you normally may off-set the amount you sell the house for by the amount you paid for the home. However, when you subtract out the amount you paid for the home, you will have to reduce that amount by any loan amount that was forgiven. As a example, if you paid $100,000 for your home, and eventually sold it for $110,000, you would only have income of $10,000, but if you had a mortgage forgiveness of $5,000, then you would only be able to subtract $95,000 from the sale price of $110,000, so that your income would be $15,000.
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