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If you’ve been through hell and back with your mortgage, having part of that mortgage forgiven by your lender may seem like a blessing. Until tax time, that is.

Before the housing market bottomed out and mortgage debt was being forgiven left and right, tax time could be a huge problem for those whose debt had been forgiven in a short sale or refinance. That forgiven debt counted as taxable income. For many, this resulted in an unexpected, huge tax bill.

In 2007, Congress enacted the Mortgage Forgiveness Debt Relief Act. Basically, the act extended tax exemption to struggling homeowners who benefited from mortgage debt forgiveness.

We were worried that this tax benefit would drop off the face of the fiscal cliff in January. Luckily, though, Congress voted to extend the benefit through 2013. So if some of your mortgage debt was forgiven by your lender in 2012, you probably can take advantage of this fact.

The rules surrounding mortgage debt forgiveness and taxes are complex and confusing, as most IRS rules are. You can find original information from the IRS on debt cancellation here and here, but the language is somewhat technical and unclear.

We’re going to clear up the confusion, so you know exactly what to do about your taxes and mortgage debt forgiveness.

Which Forgiven Debt is Excluded?

Only canceled debt that was used to “buy, build, or substantially improve your principle residence” is excluded from becoming taxable income.

In a nutshell, this means that canceled debt from your original mortgage on your main home won’t count toward your taxable income. If you used money from a partially forgiven mortgage to buy a second home or a vacation home, that money will count toward your taxable income.

Here’s how the simplest version of this looks:

The Jones family took out a $125,000 loan to buy a home worth $150,000 in 2000. In 2012, they owed $99,000 on their home, but its value had fallen to $90,000. After some other financial problems, they were no longer able to make mortgage payments and were forced to short-sell the home for $85,000.

This left the Joneses $14,000 in debt to their mortgage lender, who forgave the debt upon the short sale. Because the Jones’ mortgage was all for the original purchase of their primary home, they don’t have to add that $14,000 to 2012’s taxable income.

This same scenario would have worked if the Jones had been foreclosed on, where the bank would have forgiven their remaining mortgage debt. One final option is with mortgage restructuring. If the Joneses had negotiated for a restructuring of their original mortgage, which included some debt forgiveness, the forgiven debt would also be exempt.

Any loan used to do major renovations, including a cash-out refinance, also qualifies under this law. Here’s an example of how that works:

The Smiths did a cash-out refinance in 2005. They were able to cash out $30,000 of their home’s equity to renovate the kitchen and dining area, which would presumably boost the worth of the home. Unfortunately, by 2010, they were underwater on their home by $50,000.

They negotiated a mortgage restructuring with their lender in which $25,000 of their debt was forgiven. Because all of the debt on their home had either been for its original purpose or for a major renovation, all of that debt is exempt from their taxable income.

But if some or all of the money from a cash-out refinance or home equity loan was used to pay for a vacation, pay off other debts, or for any purpose other than renovating your primary residence, that forgiven debt does not qualify for the exemption.

The problem here is that it can be quite complicated to determine how much of a forgiven debt is exempt and how much is not, because in situations like these they’re often mixed.

Here’s one final example of how this mixed-up situation might look:

John Doe got a great deal on a home in 2003. It appraised for $225,000, but he bought it for $200,000. He took out two loans to buy the home — a $40,000 loan for the down payment and a $160,000 loan for the remaining 80% of the purchase price. Shortly after buying the home, he took out a $15,000 home equity line of credit to repair the roof. That leaves him with $215,000 of total debt.

After paying down $15,000 of the debt, Doe refinanced the other two loans into one $235,000 loan and used the $35,000 to pay off credit card bills. If Doe is eventually, through a short sale, forgiven $50,000 of debt, how much of that debt is exempt from his taxable income?

Well, it depends, and Doe needs to consult a tax professional. You can see how this situation can easily get complicated under the terms of the Mortgage Forgiveness Debt Relief Act.

What’s the Forgiveness Limit?

This is an easier question to answer. Up to $2 million of debt on your principal residence can be forgiven without that debt becoming part of your income. If you’re married but filing separately, the limit is $1 million.

I think it’s safe to say that most homeowners have nowhere near $2 million in forgiven mortgage debt, so most likely any mortgage debt directly related to the buying or major renovation of your primary home is fair game.

How Do You Claim the Exclusion?

You should receive a 1099-C Cancellation of Debt form at the end of the year from the lender who forgave the debt. The form will show how much debt was forgiven, as well as the actual market value of any property that was foreclosed on. You need to make sure that all the values — especially the value of your home (box 7) and the amount of debt forgiven (box 2) — are accurate.

You’ll also want to talk to your tax professional. Even if you normally file your own taxes, when you’re dealing with concepts as complicated and important as this one, you’ll need a professional on board.

Once you know how much of your canceled debt can be excluded from your taxable income, you’ll need to fill out Form 982 for the Reduction of Tax Attributes Due to Discharge of Indebtedness. This is the same form that’s used if your debt has been forgiven because of insolvency, certain farm-related debts, or a Title 11 bankruptcy filing.

This is a very complicated topic, so be sure to talk to your tax professional if you think any of this might apply to you. Do you have any other questions about mortgage debt forgiveness and your taxes that we can answer?

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