Here’s what you need to know about the Mortgage Forgiveness Debt Relief Act and how it can exempt you from paying taxes on canceled debt.
A Guide to the Mortgage Forgiveness Debt Relief Act
Step 1. Report Canceled Debt in Your Tax Return
The IRS considers canceled debt as income. Therefore, it is taxable. This rule proves burdensome to homeowners who have had trouble paying their mortgage.
In cases of a refinanced or restructured mortgage, or a foreclosed home for that matter, taxpayers still have to pay debt forgiveness tax for any canceled debt that results from the aforementioned agreements. This results in them becoming even more financially compromised.
This prompted the establishment of the Mortgage Forgiveness Debt Relief Act. It seeks to save qualified taxpayers from incurring tax payables associated with a canceled mortgage-related debt.
Whether you qualify for the mortgage forgiveness debt relief or not, you have to include canceled debt in your tax return. Keep in mind that the IRS legally mandates creditors to furnish the agency with a declaration of canceled debt via IRS Form 1099-C.
You might get in legal trouble if the IRS had been informed of debt cancellation which you failed to include in your tax return. As a debtor, you need to report canceled debt using the IRS Form 1040.
Meanwhile, to apply for possible exclusions, you need to fill in IRS Form 982. It is up to the IRS to review your account and decide what to exclude from your taxable income.
Step 2. Acquaint Yourself with the Mortgage Forgiveness Debt Relief Act
It pays to know your chances of qualifying for mortgage forgiveness debt relief before filing your tax return. You can do this by educating yourself on what this IRS program is all about.
For starters, the Mortgage Forgiveness Debt Relief Act allows the exclusion of canceled debt amounting to as much as $2 million. For couples filing separate tax returns, the IRS allows each spouse a $1 million tax exclusion.
Here, forgiven debt should be directly associated with a taxpayer’s principal residence. This tax debt relief covers any canceled debt resulting from mortgage restructuring or refinancing and foreclosure.
This mandate was first introduced in 2007. It initially covered canceled debts between 2007 and 2016.
Due to its successful implementation, the Mortgage Forgiveness Debt Relief Act 2018 extension became possible. The 2018 extension means that income from mortgage-related debt forgiven in the year 2017 still falls within the exclusion window, that is, if a written agreement had been made during that fiscal year.
However, keep in mind that not all forgiven debts associated with your mortgage qualify for the cancellation of debt income.
Step 3. Know the Difference Between Acquisition Debt and Home Equity Debt
According to the U.S. tax code, there are two categories of mortgage debt. These are acquisition debt and home equity debt.
The mortgage debt relief act allows tax exclusion only for the former. Home equity debt does not qualify for canceled debt relief.
However, home equity debt is recognized in cases of requested exclusions resulting from bankruptcy and insolvency.
It is important that you keep all pertinent files of your mortgage-related transactions. These records will help you better compute the current value of your house, as well as its associated debts.
The most crucial of these records includes the buyer’s agent agreement, purchase agreement, seller disclosures, closing disclosure, title insurance policy, and property deed. Home inspection reports might also come in handy, should you need to furnish the IRS with repair-related documents for when you are applying for home equity debt exclusion via bankruptcy or insolvency.
Acquisition Debt Definition: Debt incurred to build, buy, or improve a principal shelter.
Home Equity Debt Definition: Debt incurred using home equity as collateral, and spent for home maintenance and other necessary expenses.
RELATED: Mortgage Interest Tax Deduction
Step 4. Assess Whether You Qualify or Not
Speaking to a tax relief specialist, such as a tax lawyer or accountant, will work in your favor. These experts know how to best deal with the IRS, and know whether you qualify for specific tax relief options.
But if you decide to apply for canceled debt forgiveness on your own, it is best to assess your qualifications from the get-go. This will save you time, money, and effort.
Remember the exclusion window recognized by the program. Any canceled debt agreed upon after 2017 will not be honored unless the IRS enacts another extension.
Also, remember that only your principal shelter will be covered by the mortgage debt relief act. Vacation or secondary homes do not qualify unless you are filing for either insolvency or bankruptcy.
Filing for insolvency and bankruptcy as a tax relief option is technically separate from the mortgage debt relief program. However, these two options are worth discussing.
Step 5. Declare Insolvency
Insolvency happens when your liabilities in relation to your asset exceed the fair market value of the said asset, which in this case is your principal residence.
For instance, if your house’s fair market value is at $200,000 and you still have $250,000 of mortgage to pay, with $220,000 home acquisition debt, your canceled debt is $50,000. Here the amount of $30,000 equates to equity debt and the remaining $20,000 qualifies as acquisition debt.
Your $20,000 acquisition debt will be excluded from your taxable income via the mortgage relief program. Meanwhile, the IRS insolvency rule covers the remaining $30,000 equity debt, which then is subject to exclusion as well.
Step 6. Consider Filing for Bankruptcy
Although it will afford you a shot at a clean financial slate, filing for bankruptcy has its downsides and must be considered a last resort. For one thing, your bankruptcy record will remain in the public domain for 7 to 10 years after the date of filing.
Bankruptcy will also affect your credit report. And probably your self-worth, too.
However, sometimes filing for bankruptcy becomes the sole practical recourse, especially if all other options have failed.
You can avoid debt cancellation tax if your forgiven debt coincides with a bankruptcy filing. The bankruptcy court should have ordered the debt cancellation for it to be excluded from tax collection.
The Mortgage Forgiveness Debt Relief Act provides aid to taxpayers in a dire financial situation. Do not hesitate to take advantage of this tax relief option if you think you meet the needed qualifications.
For questions and recommendations, please sound off in the comments section below.
If you owe back taxes, visit taxreliefcenter.org for more information on tax relief options.