Mortgage Debt Forgiveness: Can You Find Relief?
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There is no joy like opening the doors to your new home. It is a dream for all of us and the biggest investment for many. Fortunately, there is a way of making the purchase easier on your finances – a mortgage loan. The secured loan will provide you with funds, while your home will remain collateral with the lender.
But if things didn't go as planned and a pandemic or recession has impacted your finances, it is natural to want a way out. Luckily, debt relief options like mortgage debt forgiveness are available for you. For the lender to cancel or forgive all or a part of your debt, you must qualify for a special act. This article explains how mortgage debt forgiveness works and the correct way to handle it.
In this article
Mortgage Forgiveness & Debt Relief Act
The Mortgage Forgiveness and Debt Relief Act of 2007 was passed by Congress to stop financially strapped borrowers from taking another hit during the tax period. Before this act was introduced, it was the time of the Great Recession, and Americans had to pay an additional tax on debt that was forgiven due to foreclosure. This led to additional financial troubles for them.
According to this act, when all or a part of your mortgage debt on the principal residence is forgiven, you can exclude this forgiven amount from the taxable income. It applies only to canceled debt and certain forgiven debts.
Individuals who have had their mortgage debt forgiven after a short sale, loan modification, foreclosure, or deed instead of foreclosure do not owe income tax on this canceled debt. The act also introduced the Qualified Principal Residence Indebtedness (QPRI) exclusion, where borrowers will not have to pay tax on mortgage debt forgiveness on their qualified principal residence.
Who can use the Mortgage Debt Relief Act?
This Act will apply to all the homeowners who:
- Have been granted principal forgiveness on the mortgage loan
- Did a short sale on the home
- Did a deed-in-lieu of foreclosure, and,
- Lost the home due to foreclosure or are in the middle of foreclosure.
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Applicability of the Mortgage Debt Relief Act
Principal Forgiveness
When the lender forgives or cancels a part of the debt, it is known as principal forgiveness. It can help provide financial relief to struggling homeowners who may no longer have to default on the loan. In this act, any debt the lender has forgiven will be excluded from the income and will not be subject to taxation by the IRS. Hence, you do not have to pay taxes on the debt you technically no longer owe.
Short sale
A short sale is an alternative to foreclosure that many struggling homeowners might consider. In the short sale, a home is sold for less than the balance that remains on the mortgage loan. It is sold for much lower than the market value. Here, the lender agrees to accept less than the amount outstanding on loan, and the borrower does not get any money from the sale but can avoid going through foreclosure. It can take about 6 months or more to complete a short sale.
Foreclosure
When borrowers find that they cannot make the monthly mortgage payments, the lender has a right to initiate a on the property. As per the Mortgage Debt Relief Act, the debt forgiven due to foreclosure will be excluded from the income and will not be taxed, but the process can take up to one year to complete.
Deed-in-lieu of foreclosure
An ideal alternative to foreclosure is the deed-in-lieu of foreclosure. It is suitable for homeowners who cannot afford to make mortgage payments. Through this, the borrower can surrender all interest in the property to the lender to release him from the mortgage debt obligation.
The deed-in-lieu of foreclosure is less harmful to the credit score. This process helps the lender avoid going through the entire process of foreclosure proceedings. The process could take at least three months to complete.
Steps to get mortgage forgiveness
Getting mortgage debt forgiveness will reduce the principal balance on the home loan and also involves rewriting the loan contract.
You could either opt for a loan forgiveness plan where you stay in the home under rewritten terms or choose to move out. This will still help avoid foreclosure. Here are the steps you can take to get mortgage debt relief.
Step 1
Contact the lender to inquire about the mortgage forgiveness options. Explain your financial situation and answer the questions related to your current circumstances and finances. If mortgage modification is an option, it can help reduce some or all of the principal you owe on the mortgage. Alternatively, consider a short sale to sell the house for less than the outstanding balance. The last option is a deed-in-lieu of foreclosure, where the ownership will be transferred to the lender to meet the outstanding balance.
Step 2
Collect your financial documents, including proof of income, two recent bank statements, a list of monthly expenses, and two most recent years of tax returns. Now write a letter explaining your financial hardship and why you cannot afford to pay off the principal balance. Provide all the details about the hardships and describe the steps you took to avoid default. If you opt for a deed-in-lieu, you will also have to explain why you were denied the loan modification option and failed in the short sale attempt.
Step 3
Ask your lender for a letter stating the forgiveness agreement's terms. The letter should mention the amount of principal the lender is willing to forgive or wipe off. In case of a short sale agreement, the lender should mention that he is ready to waive his right to any deficiency between the sales price and the amount owed.
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Things to keep in mind for QPRI Exclusion
When a part or all of the debt is forgiven, you may be able to avoid paying income tax on this forgiven debt through qualified principal residence indebtedness (QPRI) exclusion. But here are some important points you need to keep in mind.
- Mortgage debt forgiven in the years from 2007 to 2025 and, in some cases, after January 1, 2026 (only if you have a written agreement before the date) will be qualified.
- The debt includes mortgages that were reduced by restructuring or modification or a debt that has been canceled because of a short sale, abandonments, deed-in-lieu of foreclosure, or foreclosure.
- You should have taken this debt to build, purchase or renovate the principal residence. It must not be taken as a rental property or vacation home.
- All the proceeds from your refinanced debt will be eligible for exclusion only if you have used the amount to make improvements or renovate the principal residence and not to pay any other bills.
- As of December 31, 2020, the qualified forgiven mortgage debt amounting to $750,000 can be excluded, and if you are married and file your return separately, an amount up to $375,000 can be excluded.
- It is easier to find the amount of debt forgiven through "Form 1099-C: Cancellation of Debt.”
- When the forgiven debt is eligible for an exclusion, it is excluded from total income, and you need not pay any taxes, you will still have to report this amount to the IRS in the tax return.
- This exclusion ends on January 1, 2026, but it applies to the debts forgiven if there is a written agreement you entered into before January 2026.
Reporting the debt
Use the IRS Form 982 to claim a mortgage loan forgiveness tax break. You must report the exclusion of the forgiven debt for your loan associated with principal forgiveness, short sale, deed-in-lieu of foreclosure, or an already foreclosed home. Indicate the exclusion by checking the right box falling under Line 1. Attach the filled form to the regular income tax return.
You could still receive Form 1099-C specifying the discharge of indebtedness, but you will not have to add it to your return.
If you do not meet one of the exclusions and the amount is considered taxable income, the amount of canceled debt will go on line number 8 of other income in Schedule 1, which goes in Form 1040.
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FAQs
Can I qualify for the exclusion if the debt from my rental home mortgage was discharged?
The MFDRA will provide tax relief only for debt cancellation from primary residences. Hence, you cannot claim an exclusion in case of debt relief for the rental home mortgage. It will be considered your taxable income.
Do I claim a loss or canceled debt if I lose money in foreclosure?
Foreclosure is treated like a sale and if it has canceled debt, it will be considered income. If you have a non-recourse loan, your discharged debt is not counted toward the taxable income.
Can the proceeds of debt refinancing be used for different purposes?
No, you will not qualify for exclusion if you use the proceeds of refinanced debt for other purposes like paying off credit card debt.
The bottom line
If you have a mortgage loan and cannot make the payments, consider mortgage debt forgiveness as a last resort. Speak to a lawyer or tax professional to understand the impact of the same on your tax return. If full forgiveness is not an option, consider mortgage modification to make the repayments manageable.
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Editor
Vandita Jadeja is a financial writer and editor at Joywallet. She loves to read and write about money and brings a decade of experience from the financial industry.
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