How To Report Debt Canceled on Form 1099-C

While tragic to contemplate being forced to sell one’s home at a loss, historically taxpayers that were fortunate enough to receive some relief from their lenders also were unfortunate and were taxed on any debt forgiven. Whether via a short sale, foreclosure, or mortgage modification, the rule on debt forgiveness (where an individual or couple suddenly does not owe an amount previously borrowed), has been to tax the amount no longer owed.

However, as the housing crisis was really starting to get going in late December of 2007, Congress passed the Mortgage Forgiveness Debt Relief Act of 2007.  As a result of that legislation, people restructuring certain home loans or losing their homes via foreclosure or short sale have a reasonable chance to avoid the tax hit. Currently, this relief is set to expire on December 31, 2012.

How Do I Know if I Have Canceled Debt?

If an organization lent you money but accepts less than full repayment, it is supposed to report the amount forgiven by issuing Form 1099-C: Cancellation of Debt. A copy of Form 1099-C is sent to you and to the IRS. Generally speaking, when you receive a Form 1099-C, you were supposed to include the amount forgiven in your income.

However, the Mortgage Forgiveness Debt Relief Act provides key exceptions to the general rule of taxing the amount forgiven. In most cases, up to $2 million of debt forgiven or canceled by a mortgage lender can be excluded. While a mortgage modification, a short sale, and an outright foreclosure qualify for the exclusion, if the loans were on a second home, you are out of luck. To exclude a forgiven debt, the amount owed must be on a principal residence.

What Kind of Debt Won’t Qualify for the Exclusion?

Amounts borrowed on your home which were not used to improve (i.e., remodel), acquire, or build your home do not qualify. Home equity loans not used for remodeling are a common problem.  In addition, only your main(principal) home qualifies. So mortgages for vacation homes or amounts borrowed to acquire investment properties won’t qualify for the exclusion if their debt is forgiven under the Mortgage Forgiveness Debt Relief Act.

How Do I Ensure I Don’t Pay Tax on My Mortgage Forgiveness?

If you receive a 1099-C, TurboTax Premier will guide you through the proper questions regarding your cancellation and make the proper entries on the correct forms so you are not taxed if the cancellation of debt is related to your principal residence.

How Else Might I Avoid Tax on Forgiven Loans?

Not all debts are related to homes. Similarly, not all canceled debts are automatically included in income.  In fact, debts canceled as a result of a bankruptcy filing are excluded from income.  TurboTax Premier will also check to see if you experienced this situation.

In the spirit of making lemonade from lemons, be sure to pay attention to the tax saving opportunities available if you are able to gain some traction in reducing the amount you owe on your home. It’s quite possible Uncle Sam might help you out – or at least not make the situation any worse.