Discharged Home Mortgage Debt: Congress Extended Favorable Exclusion to Tax Year 2014

Sometimes, mortgage debt is forgiven by a mortgage-holder when a client restructures debt on a principal residence, or, loses a principal residence in foreclosure, or, sells a principal residence in a short sale. A “short sale” results when the selling proceeds are not enough to fully pay the mortgage balance and the lender must forgive the unpaid balance.  In such cases, the lender must file Form 1099-C with IRS and provide a copy to the homeowner.  Form 1099-C discloses the forgiven portion of the loan and the fair market value of the residence.

IRS maintains a computer program that matches forgiven debt disclosed on Form 1099-C with the borrower’s federal income tax return. The purpose is to ascertain whether the borrower included the forgiven amount in income.  If the borrower’s tax return does not report the forgiven debt income, IRS sends out a letter to the borrower to explain why it wasn’t reported.  This can result in additional tax, interest, and penalties.

As a general rule, if a lender forgives a borrower’s debt, the borrower must report the forgiven portion in the borrower’s gross income as “debt forgiveness income.” There are many exceptions to that general rule.

One such exception is whether the debt is “qualified principal residence indebtedness.” In which case, the borrower doesn’t have to include the forgiveness in income. This is indebtedness of up to $2 million related to the taxpayer’s principal residence.  It includes indebtedness to acquire, construct, or substantially improve a principal residence that is secured by that residence.  A “principal residence” is the residence where a taxpayer ordinarily resides a majority of the time.  And a taxpayer can have only one principal residence at a time.  Thus, the exclusion doesn’t apply to any debt forgiven on a second residence, business property, or rental property.  And it doesn’t apply to credit card debt or debt related to personal automobiles.

If the forgiven debt meets the definition of “qualified principal residence indebtedness,” the borrower should complete IRS Form 982 and attach that form to the borrower’s annual Form 1040 income tax return.

This favorable exclusion rule expired after December 31, 2013. But Congress recently extended it to qualified principal residence indebtedness that was forgiven during 2014.

Thus, any qualified principal residence indebtedness that was forgiven by a lender during tax year 2014 may be excluded from the borrower’s federal income tax return for tax year 2014. Nonetheless, the borrower should still complete IRS Form 982 and attach that form to the Form 1040 income tax return. Form 982 can be obtained on the IRS’ website.

It is also important for client’s to review the lender’s Form 1099-C to ascertain the accuracy of the figures. It is especially important to check the accuracy of the amount shown for the debt amount forgiven and the presumed value of the principal residence.  If the information on Form 1099-C is inaccurate, the client should immediately bring those inaccuracies to the attention of the lender.

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  • About the Author


    Howard L. Richshafer

    Howard Richshafer joined Wood + Lamping in 2008, and his practice is focused on civil and criminal tax problems, estate planning and probate, tax court trial work, mergers and acquisitions, and general corporate business matters. Howard is also a licensed Ohio CPA (inactive). Over the past 40 years, Howard has represented clients experiencing all types of civil and criminal tax problems with IRS. Those problems include IRS audits, IRS criminal investigations, enforced collection of unpaid tax liabilities involving levies, liens, and seizures of assets and income.

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