Many people are aware that there is tax relief under certain circumstances for cancelled mortgage indebtedness.  However, what they often fail to realize is that the transactions are also treated as sales (or dispositions) for income tax purposes and a gain or loss on the transaction must be calculated.  Determining any taxable amounts for the sale of the property and the debt cancellation can be difficult.  It requires strict financial calculations, knowledge of the tax code and diligence in completing the required tax forms.

The general rule is that debt forgiveness is taxable.  Some exceptions to this rule include bankruptcy (Title 11), qualified farm indebtedness, insolvency and certain qualified real property business indebtedness.  But now under the Mortgage Forgiveness Debt Relief Act of 2007 (enacted on 12/20/07), taxpayers may be able to exclude qualified principal residence indebtedness if the balance of their mortgage was less than $2 million (or $1 million for a married person who files a separate tax return).

There are some exceptions to debt foregiveness under the Act.  Debt foregiven through a short sale, a principal balance reduction or restructuring, as well as mortgage debt forgiven in connection with a foreclosure may qualify for this relief.  Debt forgiven on a rental home, auto loan, second home, business property, or credit cards will not qualify under the new provision. In certain situations other relief may be available.

If only a part of a loan is qualified principal residence indebtedness, the exclusion applies only to the extent the amount discharged exceeds the amount of the loan (immediately before the discharge) that is not qualified principal residence indebtedness. For example, assume your principal residence is secured by a debt of $300,000, of which $225,000 is qualified principal residence indebtedness. If your residence is sold for $200,000 and $100,000 of debt is discharged, only $25,000 of the debt discharged may be excluded (the $100,000 that was discharged minus the $75,000 of nonqualified debt). The remaining $75,000 of nonqualified debt may qualify in whole or in part for one of the other exclusions, such as the insolvency exclusion.