Mortgage Forgiveness Debt Relief Act

Before Congress passed the Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA), struggling Americans had to pay additional taxes on debt forgiven due to foreclosure. Because of the strain of these additional taxes, taxpayers usually faced even greater financial troubles than had caused them to face foreclosure in the first place.

The MFDRA created much-needed tax relief for homeowners who would lose their primary residence that year, and since 2007, Congress has continued to renew these protections. The MFDRA is a unique law, and only applies to certain forgiven or canceled debt. This article explains how the MFDRA works and what kinds of debt it covers.

Introduction to the Mortgage Forgiveness Debt Relief Act

The Mortgage Forgiveness Debt Relief Act is a federal law that provides tax relief to those who have had mortgage loan debt forgiven or canceled for certain reasons. Specifically, it allows taxpayers to exclude forgiven mortgage debt from their income tax burden.

This is important because before the act was passed, the IRS considered most mortgage debt forgiven through foreclosure and in other situations as taxable income. This designation isn’t unique, as other debt forgiveness - including certain student loan forgiveness options - has the same or similar tax implications. 

Under the MFDRA, which has been renewed every year since it was passed in 2007, the IRS will not treat certain forgiven mortgage debt as taxable income. This law also created the Qualified Principal Residence Indebtedness (QPRI) exclusion. With this exclusion, borrowers don’t have to treat certain mortgage debt forgiveness related to their primary residence as income. Because the forgiven debt is excluded in this way, borrowers don’t have to pay taxes on the debt.

The law offers significant  relief to homeowners who would otherwise face hefty tax burdens because of their lost real estate. The law was especially important during the housing market crash, which began in 2007 and only got worse in the following years.

The IRS provides useful guidance for mortgage loan forgiveness on its website to help taxpayers apply for this exclusion.

How It Works

To qualify for exclusion under the MFDRA’s QPRI exclusion provision, the debt forgiveness should be “directly related to a decline in the home’s value or the taxpayer’s financial condition.”

The following situations—all of which usually result in mortgage forgiveness—qualify for exclusion:

Foreclosure

Foreclosures are the most common situations that result in a QPRI exclusion. Foreclosure is a proceeding that allows lenders to repossess and sell a foreclosed home for fair market value. Foreclosure becomes an option for lenders when a borrower can’t make their mortgage payments, causing them to default on their home loan.

Of course, most borrowers and lenders want to avoid foreclosure. Borrowers who’d like to stay in their home have alternatives available, including loan modification or stopping or slowing the foreclosure through bankruptcy.

Loan Modification

Borrowers going through financial difficulties can sometimes modify their loans to avoid foreclosure. Loan modifications, or loan refinancing, can include changing the length of the loan repayment schedule, lowering the interest rate, or switching from an adjustable interest rate to a fixed interest rate.Debt is sometimes forgiven or canceled as a part of a loan modification agreement.

Short Sale

Short sales occur when a borrower sells their home for less than what is owed on the mortgage. The remaining balance on the mortgage can either be forgiven, or the lender can file a claim in court and get a deficiency judgment against the borrower. The forgiven debt can qualify for the exclusion.

Deed In Lieu Of Foreclosure

Through a deed in lieu of home foreclosure, borrowers can hand over the deed to their home to their mortgage lender instead of going through foreclosure. Debt is also sometimes forgiven as a part of the agreement with the lender to hand over the deed. The lender will become the owner of the home and will put it up for sale as if it were any other home on the market.

In each of these situations, when the lender doesn’t receive the full amount of the debt owed back when the home is sold, they will write off the balance of the mortgage on their taxes. To do this, the lender will send the borrower and the IRS a Form 1099-C, listing the amount they wrote off.

This written-off amount would have been considered taxable income before the MFDRA was passed. Now, it isn’t considered income, but rather canceled or forgiven mortgage debt subject to the Qualified Principal Residence Indebtedness (QPRI) exclusion.

QPRI Exclusion Eligibility

To be eligible for QPRI exclusions, your situation has to meet certain conditions.

1. Debt Must Be Forgiven During An MFDRA Eligible Year

First, the debt must be canceled or forgiven during an eligible calendar year. Unlike other federal laws, the Mortgage Forgiveness Debt Relief Act needs to be renewed every year or every few years. Most recently, the eligibility period was extended until 2026.

2. You Must Have A Written Agreement

Second, you must have a written agreement proving that the debt has been canceled by your lender. This is an important process because, in some situations, the lender may prefer to take you to court to get a deficiency judgment for the debt you owe. Before this happens, you can try to negotiate an agreement to cancel the debt.

In addition to the agreement, the lender will need to complete a Form 1099-C to show that they lost money from the mortgage. The lender is supposed to give both the IRS and you a copy. However, even if you don’t receive a copy, the lender should have still filed one with the IRS.

3. The Home In Question Must Be A Primary Residence

Third, the qualifying loan must be for a primary residence, not a vacation or second home. This is because the purpose of passing this law was to help struggling homeowners who, in many cases, need the mortgage debt forgiven through a foreclosure or loan modification. Losing a vacation home is not the same as losing a primary residence because vacation homes are considered investment properties, not homesteads.

What Kinds of Loans Qualify?

Although the QPRI exclusion usually applies to loans used to purchase a home, loans used to make significant improvements to the home itself can also qualify for the exclusion. On the other hand, loans that were used to pay other debts or make purchases not related to your primary residence, like car loans, do not qualify for the QPRI exclusion.

Lastly, some, but not all, second mortgages are eligible for this exclusion as well.

How Much Debt Does The QPRI Exclude?

The MPRA and the QPRI exclusion have been renewed or extended multiple times. Each time Congress renews the law, it has to decide how much forgiven debt can be excluded when a borrower files their taxes.

Before December 31, 2020

First, any debts canceled before December 31, 2020, are eligible for up to $2 million in exclusion. Married couples who file separately are eligible for $1 million apiece.

So, for example, if your mortgage lender canceled $2,000,010 in mortgage debt after foreclosure in 2018, you would have to report just $10 as income in addition to your other gross income for that tax year.

On Or After December 31, 2020

Since December 31, 2020, the threshold for QPRI exclusion has dropped significantly. Debts canceled after December 31, 2020, are eligible for up to $750,000 of exclusion. If you are married and filing separately, you will be eligible for up to $375,000 each.

For example, let’s say you sell your home in a short sale this year instead of going through foreclosure because you don’t want your credit score to be impacted by foreclosure. If you sell your home for $150,000 and you owed $160,000 on your mortgage, your lender will take the proceeds of the sale and may agree to cancel the remaining $10,000. The entire amount of the canceled debt ($10,000) would qualify for the QPRI exclusion because it is less than the $375,000 threshold. Still, you would need to make sure the lender filed a Form 1099-C and obtain a copy. 

How To Report The QPRI Exclusion

To report canceled or forgiven debt for QPRI exclusion, you will need to fill out a Form 982, check the appropriate box for loan forgiveness, and add the amount that was forgiven by your lender. The amount you put down on the form should match the amount in the Form 1099-C filed by the lender unless it exceeds the maximum exclusion amount.

For example, if your home is foreclosed upon in 2021 and the lender cancels $400,000 of mortgage debt, you can’t report the full $400,000 on your Form 982. You can only put down $375,000, since that’s the maximum exclusion amount currently allowed by the IRS. In this case, you would still be liable for taxes on the difference between $400,000 and $375,000, which is $25,000.

Other Options For Avoiding Taxes On Canceled Debt

If you aren’t eligible for the QPRI exclusion on your tax return, you may take advantage of other options to exclude that canceled debt from your income for tax purposes.

Bankruptcy Is An Option

One option is filing for bankruptcy. The discharge of debt through bankruptcy won’t be considered taxable income. So, if you file for bankruptcy after foreclosure of your home, any deficiency judgment can be discharged as part of your bankruptcy case. How much debt may be discharged in your bankruptcy depends on a few factors, including whether you file for Chapter 7 or Chapter 13 bankruptcy.

Report Your Insolvency To The IRS

People who are insolvent, meaning that they owe more money than they have in assets, are also excluded from paying taxes on canceled debts. To prove your insolvency and qualify for certain tax exclusions, you will need to show the IRS that the amount of debt you have exceeds the value of everything you own.

To do this, you will need to add up all of your debt and all of your assets, including any money in your bank accounts, other real estate, cars, boats, etc. You will also need to fill out a Form 982 and file it with the IRS along with your federal tax return.

Other Exclusions For Special Kinds Of Loans

There are also special types of loans, such as those for farm property, that may be excluded from tax liability. These tax breaks are covered under other laws.

If you’re not sure whether your canceled debt qualifies for exclusion, you can visit www.irs.gov. You can also search through the most recent IRS publication on the cancellation of debt, foreclosures, repossessions, and abandonments.

Let’s Summarize...

By creating the Qualified Principal Residence Indebtedness exclusion, the Mortgage Forgiveness Debt Relief Act helps a lot of people who are down on their luck and would otherwise get hit by a higher tax burden after losing their homes.

Still, it can be very hard to sort out whether you qualify for relief under this act or other exclusions intended to help folks in similar situations. Working with a local attorney can help you figure out if this is the right way forward for you or if there are other options you might want to take advantage of instead.