The Mortgage Forgiveness Debt Relief Act of 2007 allows homeowners to exclude from gross income any qualified principal residence indebtedness cancelled during 2007 through 2009. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, may qualify for this relief.
Amount realized from a short sale

If you do not make payments you owe on a loan secured by property, the lender may foreclose on the loan or repossess the property. The foreclosure or repossession is treated as a sale from which you may realize gain or loss. This is true even if you voluntarily return the property to the lender. If the outstanding loan balance was more than the Fair Market Value of the property and the lender cancels all or part of the remaining loan balance, you also may realize ordinary income from the cancellation of debt. The Fair Market Value is the price at which a willing seller and a willing buyer will trade. You must report this income on your return unless certain exceptions or exclusions apply.

Borrower's gain or loss
You figure and report gain or loss from a foreclosure or repossession in the same way as gain or loss from a sale. The gain or loss is the difference between your adjusted basis in the transferred property and the amount realized.

Amount realized and ordinary income on a mortgage debt. If you are personally liable for the debt, the amount realized on the foreclosure or repossession includes the smaller of:

• The outstanding debt immediately before the transfer reduced by any amount for which you remain personally liable immediately after the transfer, or
• The Fair Market Value of the transferred property. The amount realized also includes any proceeds you received from the foreclosure sale. If the Fair Market Value of the transferred property is less than the total outstanding debt immediately before the transfer reduced by any amount for which you remain personally liable immediately after the transfer, the difference is treated as ordinary income from the cancellation of debt. You must report this income on your return unless certain exceptions or exclusions apply.

In the past, this cancellation of debt income was reported as ordinary income on Form 1040, Line 21. In order to qualify for relief, the debt must be incurred in the acquisition, construction, or substantial improvement of an individual’s principal residence and be secured by that residence. The balance on the loan must be less than $2 million or $1 million for a married person filing a separate return. A refinanced debt is also eligible for the exclusion, but only up to the amount of the old mortgage principal just before the refinancing.

IRS Forms 1099-A and 1099-C
If you receive a Form 1099-A, Acquisition or Abandonment of Secured Property, or Form 1099-C, Cancellation of Debt, for their principal residence, you may be a candidate for this relief. A lender who acquires a residence in a foreclosure or repossession should issue Form 1099-A showing the information needed for the taxpayer to figure the gain or loss to be reported on Schedule D. However, if the lender cancels a debt on a foreclosure and must file Form 1099-C because the amount of debt cancelled is $600 or more, the lender may include the information about the foreclosure or repossession on Form 1099-C instead of on Form 1099-A.

If you receive a 1099-C form from a creditor, you must report the amount of the canceled debt as income to the IRS even though you have not actually received the money. The amount shown in Box 2 of the 1099-C form is the amount that must be reported as income.

Exemption from 1099c from taxable income
• 1099 income from the short sale of an owner occupied principal residence is exempt from income tax but must be reported.
• 1099 income from the short sale of rental property or a non-owner occupied property  does not automatically qualify for an exemption from income tax. The canceled debt is reported as ordinary income. This means all other ordinary expenses and losses can be applied to the income.  An account can help you offset the income with expenses to mitigate or eliminate the taxable impact of the 1099c income.
Exceptions from reporting income. 

The IRS recognizes the following situations where a cancelled debt does not have to be reported as income.

• Bankruptcy – the debt was already discharged through a bankruptcy proceeding.
• Insolvency – your total debts exceed your total assets at the time your debt was settled or deemed non-collectable.
• Indebtedness is due to a qualified farm expense. Indebtedness is due to certain real property business losses.
• Discharge of your debt was treated as a gift.  This is an extremely rare exclusion.
   

Insolvency
You are deemed to be insolvent if your total liabilities are greater than your total assets. Completing an insolvency worksheet will help you determine if you were insolvent at the time your debt was discharged.  For example, if your total liabilities are $8,000 and your total assets at the time are $6,000 you are insolvent in the amount of $2,000. To determine the value of your assets use the fair market value rather than what you paid for them or what you think they are worth.

If a borrower is financially insolvent when he surrenders the mortgaged property to the lender voluntarily or through foreclosure there will be no imputed income.  The property does not have to be an owner occupied principal residence.  A borrower who files bankruptcy is presumed to be insolvent, so that a bankruptcy debtor cannot suffer imputed income tax liability because the bankruptcy discharges personal liability under a mortgage note.
 

Helpful tips to avoid problems if you have received a 1099-C

• If you settle your mortgage for less than the full amount be sure to ask the creditor if they intend to submit a 1099-C form to the IRS.
• The name of the creditor may not be readily recognizable on the 1099-C form.  The creditor may have sold the debt to a third party collection agency or the name of the parent company could be listed as the creditor.
•  Look to see if the added income received from a debt cancellation will move you into a higher tax bracket. For a taxpayer in the 35% tax bracket in 2005, a $5,000 canceled debt could cost up to $1,750 in additional income taxes.
• You cannot claim that you never received a 1099-C form in the mail.  Even if you do not receive a 1099-C form you are expected to recognize ordinary income.
   

Deemed Sale
A foreclosure or short sale is considered the same as a sale or a ‘deemed sale’.  Some lenders are issuing Form 1099-A to report the foreclosure on a principal residence but no Form 1099-C. If the taxpayer was personally liable for repayment of the mortgage when the debt was created, Box 5 on Form 1099-A should be checked “yes.”   The abandonment is reported as a deemed sale of the property on Schedule D.   The selling price would be the lower of Box 2, “Balance of principal outstanding,” or Box 4, “Fair market value of property.”   If Box 2 is greater than Box 4, there could be cancellation of debt, which would qualify for the mortgage relief income exclusion.
 

Form 982
To claim the income exclusion, Form 982, Reduction of Tax Attributes Due to Discharge of
Indebtedness, needs to be filed for homeowners who receive Form 1099-C for a home mortgage which was partially or entirely forgiven during 2007. Form 982 was revised in February 2008 to add two new lines to accommodate home mortgage debt forgiveness:

• Line 1e, “Discharge of qualified principal residence indebtedness,” and
• Line 10b, “Applied to reduce the basis of your principal residence.”

If Form 982 is being used as the result of foreclosure on a principal residence to report the exclusion of forgiveness of qualified principal residence indebtedness, only Lines 1e and 2 need to be completed. If, instead of foreclosure, the principle residence was retained and a modification of the terms of the mortgage resulted in the forgiveness of qualified principal residence indebtedness, complete Lines 1e, 2, and 10b.  In either case, attach Form 982 to the client’s tax return.
 

Example:
Tom and Ann Spender bought a new home on June 23, 1990, for $70,000. This was their principal residence until Tom lost his job and they fell behind on their payments, eventually losing the home through foreclosure on May 11, 2007. When the couple walked away from their home, they still owed the bank $49,097. Due to the depressed economy, the mortgage company sold the house for $40,000 and cancelled the $12,618 debt remaining on the mortgage that was not satisfied by the proceeds on the sale of the house.

Under the new rules of the Mortgage Forgiveness Relief Act of 2007, they escape reporting the cancellation of debt as income on Line 21 of Form 1040.  Instead, Tom and Ann will report this cancellation of debt on Form 982.  On Form 982, check Box 1e and enter the $12,618 of home mortgage debt discharged on Line 2.

The foreclosure on the personal residence is treated as a deemed sale for the lesser of the amount of the balance of the principal outstanding or the Fair Market Value of the property. Any gain is eligible for the §121 exclusion if the use and ownership tests are met. Assuming the Spenders’ house has an mortgage of $77,382 and the deemed sales price is $40,000, they have a gain of $37,382 on the deemed sale [$77,382 - $40,000 = $37,382]. However, the gain is excluded under Section 121 of the IRS code as long as they owned and occupied the home as their principal residence for at least two years during the five-year period ending on the date of the foreclosure.

We are not lawyers or accountants
The information here is intended to be only illustrative and not intended for your specific individual needs. We recommend you consult a lawyer and an accountant if you want professional assurance that our information, and your interpretation of it, is appropriate to your particular situation.