Thursday, January 22, 2009

Mortgage Forgiveness Debt Relief Act Part 2

If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled 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.

Example. Assume that a residential home was purchased in 2005 for $200,000. The value of the home has declined to $180,000 and payments are in arrears. The delinquency has added interest and late fees to the mortgage balance, which is now $198,000. The mortgagee (bank) forecloses on the home and later resells it for $170,000. The result is a nondeductible loss of $30,000 and Cancellation of Debt (COD) income of $28,000.

Gain/Loss on Sale:

$170,000 Selling Price
– $200,000 Original Cost
$ 30,000 Nondeductable Loss

COD Income:

$198,000 Mortgagge and past due interest
-$170,000 Selling Price
$ 28,000 COD Deductable Loss

It is clear that the negative tax consequence is the result of two items: the low selling price received by the mortgage company, and the high debt resulting from accrued interest and penalties.

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