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Tax Exemption for Forgiven Mortgage Debt Has Strict Rules

Recently, the Internal Revenue Service issued some fresh guidance on handling canceled mortgage debt. Since there were millions of foreclosures, mortgage loan modifications and short sales last year, there are quite a few people who are interested in the tax implications of canceled mortgage debt.

Under normal circumstances, cancelled debt is treated as taxable income by the IRS. Congress, however, has created a special exemption to aid homeowners who have had mortgage debt forgiven. There are specific tests that need to be passed in order to qualify, however.

The IRS wants people to know that if a lender wrote off a portion of their mortgage debt, they don't automatically qualify for special tax treatment. The debt the lender canceled must have been used by homeowner "to buy, build or substantially improve [their] principal residence."

The property can't be a second home, an investment condo, a weekend retreat or a seasonal home that is occupied for less than half the year. It can only be a home that can be proven to be the homeowner's main residence.

Second, the canceled debt cannot have been used for cars, vacations, paying off other debts, etc. It has to be spent on the house.

The IRS also wants people to know that mortgage cancellation relief is capped at $2 million for married taxpayers, $1 million for married owners filing separately.

The IRS recommends that anyone who has had mortgage debt canceled as part of a loan modification or foreclosure should go to IRS.gov and download Form 982 and IRS Publication 4681 for additional filing details.

People who had unpaid mortgage balances forgiven can expect to receive a form 1099-C cancellation of debt statement from their lender. Orange County tax lawyers point out that this form should include the amount of the loan forgiven and the fair market value of the property.

If you have had mortgage debt canceled but haven't received a 1099-C from your lender, request it to avoid federal tax hassles.

Source: Los Angeles Times "Passing the test on canceled mortgage debt has tax rewards" 3/13/2011

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