How the Mortgage Forgiveness Act Affects Your Taxes

When a lender forgives a portion of a loan, the Internal Revenue Service (IRS) considers that canceled amount as income to the borrower. This means a homeowner who went through a short sale, foreclosure, or loan modification could owe taxes on thousands of dollars of “phantom” income they never actually received in cash, creating a financial burden.

In response to this issue, Congress enacted the Mortgage Forgiveness Debt Relief Act of 2007. This legislation created an exception, allowing eligible homeowners to exclude certain forgiven mortgage debt from their taxable income. The provision has been extended multiple times and now applies to debt discharged through December 31, 2025.

Eligibility for the Exclusion

To qualify for the tax exclusion, the forgiven debt must be associated with a taxpayer’s principal residence, which is the home where you ordinarily live most of the time. A taxpayer can only have one main home, and properties like second homes or vacation rentals are not eligible. Your principal residence is determined by factors like the address listed on your tax returns, driver’s license, and voter registration.

The law specifically applied to “qualified principal residence indebtedness.” This means the mortgage loan must have been used to buy, build, or substantially improve your main home. If a homeowner refinanced their original mortgage, the exclusion only applied to the extent the new loan amount did not exceed the balance of the old mortgage principal. Funds from a cash-out refinance used for other purposes, such as paying off credit card debt or buying a car, do not qualify.

The relief is available for debt forgiven through December 31, 2025. For the exclusion to apply, the cancellation of debt, which often occurs in a foreclosure, short sale, or loan modification, must happen by this date. The exclusion may also apply to debts forgiven after 2025 if the discharge results from a written agreement entered into before January 1, 2026.

Calculating the Excludable Debt

The law establishes specific limits on the amount of forgiven mortgage debt that can be excluded from income. The maximum amount of excluded forgiven debt is $750,000 for married individuals filing a joint return or qualifying widow(er)s. For all other filing statuses, including single and head of household, the maximum exclusion is $375,000.

A limitation in the calculation is that the excludable amount cannot exceed the portion of the debt that was qualified principal residence indebtedness. The exclusion is also limited to the outstanding loan balance immediately before the debt was canceled. This prevents a taxpayer from excluding an amount greater than the actual mortgage debt that was forgiven by the lender.

In some situations, a taxpayer might also qualify for relief under the insolvency exclusion. A taxpayer is considered insolvent when their total liabilities exceed the fair market value of all their assets immediately before the debt cancellation. If a taxpayer was insolvent and also had qualified principal residence debt forgiven, the rules require applying the mortgage debt exclusion first. Any remaining forgiven debt could then potentially be excluded under the insolvency rules.

Required Tax Forms and Information

When a lender cancels $600 or more of debt, they are required to send the borrower a Form 1099-C, Cancellation of Debt. This form reports the amount of canceled debt to both the taxpayer and the IRS. Box 2 of the form shows the amount of debt discharged, and Box 4 provides a description of the property.

To claim the mortgage forgiveness exclusion, a taxpayer must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with their federal income tax return. This form is used to report the amount of forgiven debt being excluded from income. On Part I of the form, the taxpayer must check the box on line 1e to indicate they are excluding discharged qualified principal residence indebtedness. On line 2, the taxpayer enters the amount of the forgiven mortgage debt they are excluding, up to the applicable limit.

A consequence of taking this exclusion is that the taxpayer must reduce the cost basis of their principal residence. The basis is the amount of your investment in the home for tax purposes, and this adjustment is reported on Part II of Form 982. The basis cannot be reduced below zero. This basis reduction will affect the calculation of any taxable gain if the home is sold in the future, making the tax relief more of a deferral than a permanent forgiveness.

Filing Your Tax Return

The completed Form 982 must be attached to your Form 1040, U.S. Individual Income Tax Return, for the year in which the debt was canceled. If you are filing a paper return, you will physically attach the printed Form 982 behind your Form 1040. For those who e-file using tax preparation software, the program should prompt you to fill out Form 982 and will electronically attach it to your return.

The Mortgage Forgiveness Debt Relief Act was a federal law, and not all states with an income tax automatically conformed to this federal provision. Taxpayers should check the specific tax laws for their state of residence for the year the debt was forgiven. This is to determine if the excluded amount must be reported as income on their state tax return.