How to Pay Less Tax on Forgiven or Cancelled Mortgage Debt

The IRS will collect taxes on forgiven or cancelled mortgage debt but distressed homeowners may pay less than the full amount if they file correctly.

When the bank forgives your mortgage debt, sells your home in a short sale or repossesses it with a deed in lieu of foreclosure, you no longer owe the mortgage debt. But because the mortgage had a dollar amount remaining, the IRS treats the debt cancellation as income. If you had $60,000 forgiven, it’s as though the bank handed you that amount.

While you still have to pay tax on it, you may not have the burden of paying for the whole mortgage debt, according to enrolled tax agents Bill Nemeth, Chet Burgess and Merry Brodie.

“No matter how it happened, if she sold it outright or the bank repossessed it or there was a deed in lieu, there was a disposition of the property and that transaction… has to be reported,” says Brodie, an enrolled agent at Tax Audit Guardian in Atlanta. The sale must be reported if you rented the house because it is considered business property.

To report it, you need to file a 1099A form and it’s crucial that it’s done correctly.

“A lot of preparers will put it on line 21 as other income… and it’s much more complicated than that,” says Nemeth who is also an enrolled agent at Tax Audit Guardian.

A tax exemption called the Mortgage Forgiveness Debt Relief Act of 2007 allowed taxpayers to exclude income from debt forgiveness on their principal residence. It expired on December 31, 2013 but you still might be able to pay less tax than the forgiven debt amount.

The tax you owe may be less if the house is sold at a loss.

The IRS treats your debt cancellation as separate from the sale of your property. If the bank sells your house for much less than it was worth, you won’t have to pay as much tax on the house because the value has decreased, according to the market.

“I’ve had a number of clients where we’ve put a return on extension and waited several months until the banks actually sold the property,” says Burgess, an enrolled agent at Brookwood Tax Service, LLC in Atlanta. “It sells for way less than the value of the mortgage.”

If the house sells at a loss, there’s a possibility you won’t have to pay as much in taxes. For example, if your mortgage debt was $60,000 when it was forgiven by the bank but the bank only sells the house for $40,000, you’re not subject to as much tax because the house is valued by the market at $20,000 less than what you owed.

The homeowner should wait to see if there is a gain or loss on the property first. Then you can combine the sale price with the total cancellation of debt to figure the tax amount, Burgess says.

File the 1099A or 1099C with an enrolled agent, Certified Public Accountant (CPAs) or someone with tax credentials.

Debt reductions or cancellations are complicated and vital to your financial life. If you file with a national agency, ask for a floor manager, says Nemeth. If you usually file yourself, seek professional help this year.

In addition to the 1099A, the banks may also issue a 1099C, which is a notice to the IRS that the financial institution has forgiven or canceled a debt of $600 or more.

“Frequently lenders are issuing a 1099A at the time of a foreclosure and then sometimes a year later they spit out a 1099C, when they actually write off the loan on their books,” Burgess says.

A 1099A can fall through the cracks but a 1099C will alert the IRS to tax the income. If you already accounted for a 1099A last year, the bank may have waited until this year to issue a 1099C. It’s possible that you will have to account for the debt cancellation on your taxes.

Stay in contact with your lender and an enrolled agent or CPA so that you can possibly pay less tax than the whole mortgage amount.

WSB Radio’s Ilyce Glink Show – February 23, 2014

Click the audio link below to listen to the full Ilyce Glink Show on WSB Radio, or go to iTunes and download the show to your handheld device.

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About Ilyce Glink

Author of 13 books, including the bestselling 100 Questions Every First-Time Home Buyer Should Ask. Writer of the nationally syndicated column, “Real Estate Matters.” Top-rated radio host in Atlanta. Writer for CBS MoneyWatch.com. Managing editor of the Equifax Personal Finance Blog.
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