Under IRS guidelines, if a debt is resolved for less than the full amount due, it results in a Cancellation of Debt (CoD). In the mortgage setting, the amount of debt forgiven is the difference between the fair market value of the property at the time of sale and the amount owed on the mortgage debt.
Mortgage Debt: $300,000
Fair Market Value: $200,000
Canceled Debt: $100,000
So, even if the mortgage company does not seek a personal deficiency judgment, there may still be substantial tax consequences. Under IRS rules, the mortgage company should issue either a 1099-A or a 1099-C for the cancelled debt. That income then needs to be reported on the borrower's tax return.
Assuming the borrower makes $60,000 per year, is married, and has two children, and has no other deductions or tax issues, the borrower's federal income tax liability is around $1,950. However, adding in the canceled debt income of $100,000 means that the borrower's federal income tax liability increase to around $26,900 - an increase of almost $25,000.
Exceptions to Taxation of Cancellation of Debt
There are several exceptions to the taxation of cancellation of debt income. One common exception is insolvency. Insolvency is when someone's overall liabilities are higher than their overall assets. The calculation is made at the time of the cancellation of debt. One significant issue with insolvency is that things like retirement accounts and pensions factor into the analysis - so even if a borrower doesn't otherwise have a penny to his name, and can't touch his retirement or pension for another 20 years, it can still cause the taxation of canceled debt income.
One of the most common exceptions to taxation of cancellation of debt income is bankruptcy. Bankruptcy discharges all personal liability on debt, so while a 1099 may still be issued, that cancellation of debt income would not be taxable.
Tax Form 982 is used to except debt from taxation and is filed as part of the tax return.
Mortgage Forgiveness Debt Relief Act
Until December 31, 2013, cancelled debt on a mortgage on a primary residence was excepted by the Mortgage Forgiveness Debt Relief Act. However, that act expired on December 31, 2013.
Many groups, including the National Association of Realtors, have called for another extension of the act. Whether that extension will happen or not remains to be seen.
***Disclaimer: Nothing in this post should be construed as tax advice, and if one has tax questions, one should speak with a tax professional for specific advice about his or her situation.