July 23, 2019

Doesn’t the IRS Say My Debt Forgiveness Income Can’t Be Taxed?

All this talk about mortgage principal reduction and mortgage modification in the general press is incomplete and often confusing. People searching for answers can even find that information on government websites is too general for their specific needs.

Take, for example, debt forgiveness income. This IRS page on The Mortgage Forgiveness Debt Relief Act and Debt Cancellation is helpful.

Is Cancellation of Debt income always taxable?

Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:

  • Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
  • Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
  • Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
  • Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.
  • Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.

Who am I to take issue with the IRS?  Well, from my experience I feel obliged to qualify some of these statements.

The third bullet on insolvency: I hear this can be very time consuming and difficult to prove. The taxpayer needs an accountant to fill out and submit the required form, which the IRS often contests — all at a cost to the taxpayer.

The last bullet on non-recourse loans: This is a bit of a red herring, because one almost never sees a non-recourse loan. The statute is so easily avoided it’s pretty meaningless.

Whether debt forgiveness income is triggered is a legal and accounting question that depends completely on the facts of the case. Even if there is no debt forgiveness income resulting from a mortgage modification, and thus no tax consequence, 95%+ of my clients who cannot pay their mortgage as it becomes due have substantial other debts that they also cannot pay as they become due. This may be tens of thousands of dollars in credit card debt; medical debt; tax debt; business debt; or other debt.

If mortgage modification will still leave you with debts that you are unable to pay, then mortgage modification is not the answer to all of your problems. I wrote this Primer on Bankruptcy for Distressed Homeowners to help you understand some options.

A bankruptcy counseling session with a qualified advisor is the best way for you to know what will help you, specifically.

This is a bit of a red herring, if you’re planning to post this on the website.  I have never seen a non-recourse loan in all my years doing this.  The statute is so easily avoided it’s pretty meaningless.