How to Avoid Cancellation of Debt Income in Foreclosure

Taxes, debts and other problems.
Many homeowners under threat of foreclosure attempt a short sale or a deed-in-lieu-of-foreclosure. Their goal is to escape liability for a potential deficiency between the selling price of the distressed property and the amount owed on the original loan. For federal income tax purposes, such a cancellation of debt (COD) is generally considered ordinary income when the lender forgives the mortgage debt. Many distressed homeowners face the risk of not only losing their homes but also owing thousands of dollars in income taxes on the forgiven mortgage debt.

Fortunately, Congress passed the Mortgage Forgiveness Debt Relief Act (MFDRA) of 2007, which relieves COD taxation on debt forgiven on principal residences. Secondary loans on a primary residence also are exempt if forgiven, but only if the money from these loans was used to purchase or improve the property. Advocates should be ready to demonstrate that their client’s property was, in fact, used as a primary residence to qualify for the MFDRA’s relief.

Even if homeowners do not qualify under the Mortgage Forgiveness Debt Relief Act, some common law and statutory exemptions may provide relief. First, indebtedness discharged as part of a bankruptcy is exempt from cancellation of debt (COD) income. Second, a purchase-price exception provides that when an original lender bargains with an original purchaser, a reduction in principal may be deemed an exception to COD income in cases of failing market conditions or reduced property values. If the lender issues you a 1099-C, then you will have to file IRS form 982 with your federal 1040 income tax return to avoid paying tax on the COD income.

If you face foreclosure or get a 1099-C for Forgiveness of Debt Income, please call Gregory J. Spadea at 610-521-0604 in Ridley Park, Pennsylvania.

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