Want to know if you need to pay taxes on a loan modification? We answer a question about loan modification today.

Q: I modified my home loan last year following my divorce at the end of 2011. My first new payment on the modified loan was at 3.1 percent, down from a 9 percent rate. My house payment went from $1,300 a month to $529.

This reduction made the loan affordable for me and I get to stay in my home with my son. This year, I received a 1099-C from my lender telling me that I have to declare an extra $25,000 in income due to the loan modification. My house is only now worth about $78,000 and I owe almost $100,000.

If I have to report this income, I’ll owe $2,800 in taxes. That’s money I don’t have. Can they do this? Is there any way around this?

A: You are actually quite lucky to have received a loan modification. You are even luckier to have received a loan modification that also must have included some reduction in the amount of debt you owe the lender. Not many homeowners have been able to get either of these accomplished. That’s the good news.

The better news is that you probably don’t owe any federal income taxes as a result of the loan modification. Your lender was required to send you the 1099-C. The 1099-C shows the amount of debt that your lender cancelled or waived in connection with your loan. It appears that your lender wiped $25,000 off what you owe them, but they now report that to the IRS as if the lender gave you a taxable gift of $25,000.

Fortunately, Congress extended a tax benefit to homeowners that are in your shoes or have gone through a short sale or foreclosure and the lender has decided not to pursue the borrower for money owed. When a lender cancels all or a portion of a debt owed, that cancellation is a “gift” to you – you no longer need to repay that cancelled debt. But this tax benefit only works with a person’s primary residence.

In your case, you get a loan modification that allows you to keep your home and while you have to report the cancellation of debt, you won’t have to pay any taxes resulting from that cancellation.

For more information on canceled debts related to a person’s primary residence, you can look at IRS Publication 4681 (2012), which is available for a free download at IRS.gov.

You can also use the Interactive Tax Assistant on the IRS website to walk you through some of the general questions relating to the cancellation of indebtedness. If you decide to use the Interactive Tax Assistant for this issue, search the words “cancellation of debt” and the system will go through about 10 questions to tell you whether you will have a tax to pay on the cancelled debt.

The ITA (Interactive Tax Assistant) is relatively friendly, but you might have some decisions to make with some of the questions that might be confusing to you. Among the answers you’ll need to give are:

• The year in which the debt was cancelled (2012);
• The reason the debt was cancelled (in your case it was a loan modification);
• Whether you were personally liable for the debt (presumably you signed the note with the lender and you had the obligation to pay the lender off);
• Whether the lender intended the cancellation of the debt to be a gift to you (if the lender didn’t intend for you to repay them, the cancellation could be considered a gift to you);
• The original amount of your loan and the reduced amount ($100,000 loan reduced to $75,000);
• Whether the cancellation was due to your bankruptcy (no);
• Whether you were insolvent before the debt was cancelled (no);
• Whether the debt you had was used to purchase the home (yes);
• Whether the reduction in the debt was due to your home value’s decline (yes);
• Whether your lender sent you a 1099-C (yes);

For our other readers, their answers might change, but the IRS ITA will walk them through the 10 or so questions and will tell them whether their cancelled debt will be taxable or not.

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