In 2007, Congress pass the Mortgage Forgiveness Debt Relief Act (MFDRA) and initially set it to expire at the end of 2012. This temporary change to the IRS tax code permitted an exclusion for cancelation of debt income associated with forgiven mortgage debt. The Act was later extended for the 2013 tax year, but then expired again on December 31, 2013.
The MFDRA has been hugely beneficial for consumers who lost homes to foreclosure or short sale. Let’s say you did a short sale and the lender forgave $100,000 of mortgage debt as part of the agreement. Without the Act in force, that $100,000 of forgiven mortgage debt would be treated by the IRS as taxable income! We’re not talking about a capital gain taxed at 15%, but rather ordinary income taxed at 25% to 35% or more, depending on your specific tax situation. Hello, unexpected tax bill for $25,000 to 35,000 or more!
It’s true that another exemption exists for those who were insolvent just before the cancelation of debt. But for the person with retirement accounts or other assets that exceed total liabilities prior to the cancelation, the insolvency exclusion is not available.
Throughout calendar-year 2014, tax professionals and realtors specializing in short sales have been deeply worried that Congress would not extend the Act again, leaving many Americans with a stiff tax bill they hadn’t planned for. But fortunately, the Mortgage Forgiveness Debt Relief Act has officially been extended again for 2014. This retroactive extension was signed into law by President Obama on December 19, 2014 (better late than never!), as part of the late session spending bill approved by both the House and Senate.
This is great news for people who had primary home mortgage debt canceled during 2014. If the MFDRA had not been extended, hundreds of thousands of Americans who lost their homes or sold short last year would have had to pay massive tax bills on income they never actually received.
What will happen for the coming 2015 tax year remains to be seen, although there is no question the right thing for Congress to do is extend the MFDRA again for mortgage debt canceled during 2015. There are still too many homes underwater, too many houses in the foreclosure pipeline for this exclusion to be allowed to expire again.
It’s important to understand that the relief provision is limited to “qualified principal residence indebtedness,” which is defined as any mortgage you took out to “buy, build, or substantially improve your main home.” Income, rental, or other commercial property does not qualify.
If you had a cancelation of qualified principal residence debt in 2014, it is not necessary to calculate solvency vs. insolvency. The Act permits an exclusion of taxable income up to $2 million of forgiven qualifying debt, without respect to the financial position of the debtor.
You may also face a situation where only part of the forgiven debt is qualified principal residence indebtedness. In this case, the difference can still be excluded if you would otherwise be able to claim insolvency. For example, many home equity lines of credit (HELOCs) do not qualify as principal residence indebtedness because they were not used to buy, build, or improve the property.
Let’s say you sold short a property where $100,000 of qualified first mortgage debt was forgiven, and a $50,000 HELOC (used to pay off credit card debt) was also wiped out and canceled. You can claim the exemption for principal residence indebtedness only for the $100,000 first mortgage. The HELOC does not qualify for this exclusion because the $50,000 of cash was not used to buy the home or finance home improvements.
You can, however, still claim the insolvency exemption for that $50,000 of forgiven HELOC debt, provided you were insolvent by more than $50,000 just before the cancelation.
Regardless of whether you are claiming insolvency or just the relief granted under the MFDRA, you must still submit Form 982 with your Federal Form 1040.
To assist those who are struggling with the official IRS Instructions for the “tax form from hell” (i.e., IRS Form 982, “Reduction of Tax Attributes Due to Discharge of Indebtedness”), zipdebt.com offers the Form 982 Calculator for only $29. This easy-to-use calculator will save you countless frustrating hours filling out this notoriously difficult tax form.