From 2007 through 2012, taxpayers can exclude income from the discharge of debt on their residence. A discharge of debt is what occurs after a successful Chapter 7 bankruptcy. It used to be you were responsible for some discharged debt even after Chapter 7 bankruptcy. Now, with the Mortgage Relief Act of 2007, you can exclude income made from certain debts discharged. The IRS website goes over how this works in detail, but lets ask general questions you likely have on how this effects you, your family, and your pocket book.
How Cancellation of Debt Occurs
When you borrow money money, and the debt is canceled or forgiven by the lender, you sometimes have to consider this canceled debt income for taxes. If you borrowed $50,000 dollars, and paid by half of that, $25,000 would be considered as income for tax purposes. So if you bought a home for that price, you can expect some of the resultant debts to show up after bankruptcy.
What is Cancellation of Debt?
If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the canceled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.
Here’s a very simplified example. You borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you.
More Info on The Cancellation of Debt and Taxes
This income isn’t always taxable. The most important part of the Mortgage Debt Relief Act of 2007 was how it applied to homeowners; if you have a qualified principal residence which went into foreclosure or where the debt was forgiven, you do not have to pay taxes on the forgiven debt.
Also, debts discharged through bankruptcy are not considered taxable income by the IRS. There are other ways your canceled debt may not be taxable, but let’s focus on the Mortgage Debt Relief Act of 2007 and how it applies to debtors and home owners.
How the Mortgage Forgiveness Debt Relief Act of 2007 Works
If you have debt reduced by mortgage restructuring or by foreclosure, you qualify for the relief. If on the other hand you are going into bankruptcy, your debts are not forgivable in most cases. That does not mean that you’ll lose your home, but mortgage debt isn’t part of Chapter 7 bankruptcy. If you are earnest in wanting to keep your home, Chapter 13 bankruptcy can buy you time to pay back the loan. If you on the other hand are considering foreclosure, you may consider the Mortgage Act of 2007 as a means of relieving debt.
