Posted by Income Taxes and Bookkeeping LLC

Tricks to Avoid Taxes on Cancelled Mortgage Debts

Tricks to Avoid Taxes on Cancelled Mortgage Debts

Including Forgiven Debts With Income 

Almost everyone who gets a debt forgiven will get a Form 1099-C (Cancellation of Debt) from the lender, which reveals the amount of debt cancelled. Such 1099-C will be filed with the federal tax return, while the cancelled debt amount will be summed up with your gross income. 

Some exclusions and exceptions exist that might save you from classifying and reporting cancelled debts as income.

 

Exclusions and Exceptions 

All cancelled debts are not necessarily subjected to income tax. Uncle Sam understands the exceptions to forgiven debts alongside the amounts excluded from the gross income due to origin. Some exceptions are:

  • Inheritance and gifts

  • Some student loans that qualify

  • Qualified price reduction that a seller offered

  • Some payment on the mortgage balance

For loans secured through property, with a mortgage in which the house and land represent the collateral, the lender considers such property as partial or complete settlement for the debt; such is not a forgiven debt for tax purposes but sales. For this, one might have to report capital losses or gains on the property sales without having to add debts forgiven to the income with exclusions as follows:

  • Debts procured in insolvency or Title 11 bankruptcy 

  • Cancelled farm debt that qualifies 

  • Cancelled real property debt that qualifies

Claiming exclusion disqualifies you from claiming capital losses or tax credit or even improving your tax situation with excluded property.


2017 Mortgage Debt Relief Act (MDRA)

While it only applies to the principal residence, the MDRA removed all debts discharged up to $2 million as income. Provisions from this Act apply to many homeowners who also take care of partial debt relief from mortgage restructuring and complete foreclosure. While refinancing is also possible, it was only allowed up to the value of the principal balance of the original mortgage. 

The Act also takes care of subsequent debt forgiveness for funds borrowed to improve your primary residence. One cannot use the Act's provision for cancelled debts, while the debt relieved need to secure the primary residence. This also applies to debt discharged in 2021 as long as a written agreement exists in the previous year- 2020.

  

Extension of Mortgage Debt Relief Act 

While this Act only covered three years (2007 to 2010), there was a five-time extension (2012 to 2014, 2016 to 2017, and 2019 to 2020). Debts discharged in 2021 are also involved as long as they had a written agreement in 2020.

 

A Special Way Around the Tax 

You have two important exceptions to the cancelled debt rule for people not covered by the tax break for the principal residence route explored above.

Cancelled debt is different from income, not minding if you got a 1099-C if:

  • The cancelled debt came as a result of bankruptcy 

  • You became insolvent immediately before such cancellation

By insolvency, we mean the value of your debt is more than your entire asset. It is possible to exclude cancelled debts from income up to the insolvent amount. 

  • For example, someone with an asset of $50,000 and a debt of $90,000 is said to be insolvent by $40,000. 

  • Assuming the person had $60,000 cancelled in debt at the insolvency time, you only need to include $20,000 in your income: ($60,000 minus $40,000)

With complex finances, cancelled debts can be financially challenging. Get in touch with a tax professional that will guide you through essential things you need to know alongside legislation to cushion any effect of this strict legislation.


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