When Can Mortgage Debt Forgiveness Be Tax Free

Last week we talked about the fact that as of January 1, 2013 a person, who loses their home, because he or she cannot pay their mortgage, might have to report the amount of unpaid mortgage debt as taxable income, on his or her tax return. This could prove very costly for individuals, who go through a foreclosure, dispose of their home in a short sale, or sign the title to their home over to the mortgage company in a deed in lieu of foreclosure.

This is because the general rule in the Internal Revenue Code provides that a forgiveness of debt creates taxable income unless the debtor files bankruptcy  or is insolvent. When the housing market collapsed, Congress passed a temporary law to avoid the tax on mortgage indebtedness under certain circumstances, and the law is scheduled to expire at the end of 2012. Of course our lawmakers have made it a regular habit of extend tax laws about to expire at the last minute, so it is still possible, we will continue to have this relief available.

What I wanted to point out today were the requirements for avoiding tax on mortgage forgiveness under the "temporary" law. In the first place a taxpayer can only claim the relief, if the  mortgage is on his or her principal residence. A person will be out of luck, in the case of a vacation home or rental property.

Furthermore, the forgiven mortgage must be home acquisition indebtedness. If a homeowner paid off the original mortgage and took out a new loan on the house to make investments, she will have to pay income tax on the debt she does not have to pay. Qualified acquisition cannot exceed $2,000,000 or $1,000,000 for a married individual filing separately. It can include mortgage indebtedness for substantial improvement of the residence. It can also include refinancing of home acquisition indebtedness provided the amount refinanced does not exceed the original acquisition debt.