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Certain types of forgiven mortgage debt are free from taxation

The home mortgage crisis hit many California homeowners hard, leaving some with underwater mortgages and others with foreclosed homes. Those who had mortgage debt forgiven through a foreclosure sale are not out of the woods yet, however. The amount of the debt forgiven by lenders may be subject to taxation.

Traditionally, when a creditor forgives a debt, the IRS deems the amount forgiven as income to the debtor. To address the growing difficulties of the housing crisis, Congress altered this rule by passing the Mortgage Forgiveness Debt Relief Act of 2007. The Act specifically exempts certain types of mortgage debt from inclusion in a person's taxable income if the debt was forgiven from 2007 to 2012.

It is important to remember that not all forgiven mortgage debt is exempted. First, the debt must have been incurred to build, purchase or create "substantial improvements" your principal residence, and the house must serve as security for the mortgage. Refinanced debt can still be exempt as long as it meets the "substantial improvements" criterion.

But any refinanced debt used in other ways, such as to pay off an auto loan, would not qualify for the exemption. In addition, debts forgiven on a second home mortgage would also be outside the Act's circumference.

Even if some of your debt qualifies under the Act, there are dollar limits on how much debt can be excluded from taxation. That limit is $2 million, or $1 million if the taxpayer's filing status is married filing separately.

Taxpayers who had mortgage debt forgiven in 2011 will have to fill out a Form 982 and include it with their tax return. An experienced tax attorney can ensure that a person pays the correct amount of taxes, if any, on forgiven mortgage debt.

Source: Internal Revenue Service, "Mortgage Debt Forgiveness: 10 Key Points," IRS Tax Tip 2012-39, February 28, 2012.

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