The Mortgage Debt Relief Act: How It Works
Learn how the tax code treats forgiven mortgage debt on a principal residence and the specific conditions for excluding it from your taxable income.
When a lender forgives or cancels a debt, the Internal Revenue Service (IRS) generally requires the borrower to treat that canceled amount as taxable income. This can create a significant tax liability for individuals already in financial distress.
An exception to this rule is provided by the Mortgage Debt Relief Act of 2007. This law allows certain homeowners to exclude forgiven mortgage debt from their taxable income. Originally enacted to address the housing crisis, this relief has been extended multiple times, and the Consolidated Appropriations Act of 2021 made it available for qualifying debt forgiven through December 31, 2025.
Eligibility for the Exclusion
To qualify for this tax relief, the forgiven debt must be associated with a “principal residence,” which the IRS defines as the home where you live most of the time. A taxpayer can only have one principal residence at any given time. Vacation homes or rental properties are not eligible for this exclusion.
The debt itself must meet the definition of “qualified principal residence indebtedness.” This is a mortgage taken out to buy, build, or substantially improve your main home. The debt must also be secured by that same principal residence.
This relief applies to mortgage debt forgiven in several common scenarios. These situations include a mortgage restructuring or loan modification, a foreclosure, or a short sale where the home is sold for less than the outstanding mortgage balance.
Calculating the Excludable Amount
The amount of forgiven mortgage debt that can be excluded from income is capped. For most filing statuses, including single, head of household, and married filing jointly, the maximum exclusion is $750,000. For taxpayers who are married but file separately, the maximum exclusion is $375,000.
The exclusion only applies to the portion of the debt that is “qualified principal residence indebtedness.” If a mortgage was refinanced and the homeowner took cash out for purposes other than improving the home, that portion of the forgiven debt is not eligible for the exclusion. For example, if a homeowner had a $200,000 mortgage and refinanced it for $250,000, using the extra $50,000 for other debts, only the original $200,000 portion of the loan qualifies.
If the lender later forgives $60,000 of the $250,000 loan balance, the calculation must be done carefully. The forgiven amount is applied first to the non-qualified portion of the debt. In this scenario, the first $50,000 of the forgiven debt would be attributed to the cash-out portion and is considered taxable income. The remaining $10,000 of forgiven debt could be excluded from income under the Act.
Required Tax Forms and Information
To claim the mortgage debt exclusion, you will need information from Form 1099-C, Cancellation of Debt. Lenders are required to issue this form when they cancel a debt of $600 or more. This form details the amount of debt discharged and provides other relevant information you will need.
The central document you must file is Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. This form is used to report the amount of forgiven debt that is being excluded from income. On Form 982, you must indicate the exclusion is for a principal residence and enter the amount of the excluded debt.
A consequence of taking this exclusion is the requirement to reduce the basis of the principal residence. The basis is the cost of the property, including certain settlement fees and the cost of improvements. This reduction is equal to the amount of the excluded forgiven debt but cannot reduce the basis below zero. This adjustment is important because a lower basis will result in a larger taxable capital gain if the home is sold in the future.
How to File for the Exclusion
The taxpayer must attach the completed Form 982 to their annual federal income tax return. This applies whether they are filing Form 1040 or another version of the main federal tax return.
This exclusion is a matter of federal tax law, and state tax laws regarding the treatment of canceled mortgage debt can vary. Some states may not conform to the federal rules, potentially requiring the forgiven debt to be included as income on the state tax return. Taxpayers should verify the specific rules for their state.