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Is My Cancellation of Debt Tax-Free?

I bought my condo in 2010.  I was living the American dream.  Life was good and then about a year later my circumstances drastically changed.  I was laid off from my company.  Suddenly paying my once very manageable mortgage became increasingly more difficult.  I began to struggle and had to dip heavily into my savings.

I fortunately was able to secure another job before I was no longer able to pay the mortgage.  However, there are thousands of Americans who were not as lucky as me.  Many Americans were forced to default on their mortgages during this recession. Often times, they had to bring in the help of an attorney to negotiate with banks on either a principal deduction, do a short sale or worse yet foreclose on their homes.

I have seen some friends go down the path of foreclosure.  Trying to rebuild and recover from the foreclosure process is challenging.  A common question many foreclosed homeowners have is “what taxes will I be expected to pay on the amount the bank forgave me on my foreclosed home”.  That is a very good question.

Under the 2007 Mortgage Forgiveness Debt Relief Act, foreclosed homeowners that qualify can be relieved from paying taxes on cancellation of debt.  Cancellation of debt is when you are forgiven the amount of money borrowed from the bank.  Even though the bank has forgiven you the money borrowed, the IRS has not.  For the IRS, the amount of money forgiven becomes taxable income.  You are therefore required to pay taxes to the IRS on this money.  For example, let us say I had a loan for $100,000 of which I paid $20,000 off to the bank before I defaulted on my loan.  The bank decides to forgive me the remaining $80,000.  That $80,000 is now considered my cancellation of debt which I must report to the IRS.  It is seen as taxable income and I will now be taxed upon it.

Foreclosed homeowners are going to have a hard time paying these taxes.  That is why the Mortgage Forgiveness Debt Relief Act was put into effect.  It gives these homeowners much needed relief to properly recover.   If you find yourself in this particular situation, you may be eligible if the property is residential, the balance of the loan is under $2 million (or $1 million if individual), and the debt was non-recourse.  These are only a few of the eligibility requirements.   To find out whether you meet all eligibility requirements, you should check the IRS website on Mortgage Forgiveness Debt Relief Act eligibility.  If you need further assistance, I would recommend speaking with an attorney.