New IRS Rules 4 Debt Canellation

Mar 29th, 2010 | By | Category: Lead Article, Market At A Glance, Market Update

Canceled Debt | The Sahuarita ConnectionThe IRS issued a new advisory March 4 to give financially troubled and underwater borrowers step by step instructions on how to qualify for tax relief when a lender agrees to lower their debt.  Prior to the current mortgage crisis, the IRS treated any forgiveness of debt as taxable income. For example, if your lender agreed to accept $150,000 to “pay off” a $200,000 mortgage, the IRS could tax the $50,000 difference as income.  Under legislation passed in 2007, certain mortgage debt cancellations obtained through loan modifications and short sales were exempted from tax treatment as income.  The new guidelines spell out the rules for debt relief tax exemption. The rules are complex, so please treat this as general information and seek legal advice if you are considering a short sale or loan modification that involves principal reduction.*

Here are the basic rules:

• The federal tax exclusion only applies to your primary residence. It does not apply to investment homes, business property or second homes.

• In order to qualify, the debt reduction can only be for loans that were used to “buy, build, or substantially improve your principal residence”. If the funds from your home equity loan or refinanced loan were used for expenditures such as paying off bills, buying new toys, or anything that isn’t directly related to the improvement of your principal residence, you are not eligible for tax exclusion.

• If your debt is reduced or eliminated you normally will receive a year-end statement, Form 1099-C, Cancellation of Debt, from your lender. By law, this form must show the amount of debt forgiven and the fair market value of any property foreclosed.

• Claim the special exclusion by filling out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attach it to your federal income tax return for the tax year in which the qualified debt was forgiven.

• For more information about the Mortgage Forgiveness Debt Relief Act of 2007, visit A good resource is: IRS Publication 4681: Canceled Debts, Foreclosures, Repossessions and Abandonments. Taxpayers may obtain a copy of this publication and Form 982 either by downloading them from or by
calling 800-TAX-FORM (800-829-3676).

* Again, you are advised to seek legal advice from a tax attorney or Certified Public Accountant.

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