Under normal circumstances, this debt would be taxable because you received the money (in the form of the home) when the loan was made under the assumption that the money would be paid back. Since it will no longer be paid back, the IRS wants to tax you on what it considers income to you. Fortunately, Congress has recently passed legislation to assist individuals who found themselves in difficulty as a result of the crazy real estate market these past few years. If the following requirements are met, you will not be taxed on the forgiven debt amount:
- The mortgage must be on your primary home.
- The money from the loan must have been used to buy, build or substantially improve your primary residence
- The primary home must be the security on the loan.
The requirements become a little more complex when dealing with refinanced debt. Proceeds from the refinance must have been used to buy, build or substantially improve your primary home and the tax exclusion is limited to the principal value of the old mortgage prior to the refinance occurring. Additional funds taken out at the time of the refinance, if now forgiven, will not qualify and will be taxable.
If some or all proceeds of a refinance were used for other purposes than buying, building or substantially improving the primary home, those proceeds will be taxable after the lender forgives the debt. For instance, if you paid off your credit cards or other debt when you refinanced, the forgiven amount used for that purpose will be taxable.
If you qualify for the mortgage debt exclusion, the maximum amount allowed for exclusion is $2 million, with $1 million as the maximum for a married individual filing a separate tax return. Talk to your tax professional to determine if your circumstances qualify you for this exclusion.