The Mortgage Debt Relief Act of 2007

• In 2007, President Bush signed the Mortgage Debt Relief Act, which provides tax relief for qualified borrowers who had their homes foreclosed between 2007 and 2012. It also provides tax relief for homeowners who sold a home via short sale or who had the terms of a mortgage modified by the lender. To qualify, the debt must be secured by the home -- credit card bills don't count -- and the debt must have been used to purchase, build or renovate the property.
  
  

Additional Requirements

• According to the IRS, up to $2,000,000 of mortgage debt can be forgiven for a "qualified principal residence," which means that the debt must have been secured by the home. Married filing separately? Then the exclusion is $1,000,000. If the balance that was forgiven was greater than these limits, the IRS instructs the taxpayer to review Form 982, which is used to report canceled debt. However, even if the taxpayer qualifies for the exclusion, he must still report the amount forgiven to the IRS on Form 982.
  
  

How Cancellation of Debt Works

• If a consumer borrows money and later defaults on the repayment of the loan, after a period of time the outstanding debt may be canceled -- meaning the homeowner no longer owes the lender the remaining balance. This may occur because he has settled the debt for less than what's actually due. The difference between the settlement -- or the foreclosure sale price -- and the loan balance is the "forgiven" amount. Prior to 2007, in a foreclosure, the forgiven balance was reported to the IRS on Form 1099-C, Cancellation of Debt Income, and added to the borrower's taxable income.
  
  

Other Exceptions to Cancellation of Debt Income

• The Act is not the only rule that protects struggling borrowers. Debt that's eliminated through a bankruptcy filing is not taxable. In addition, if the borrower is insolvent, the debt income is not taxable. In order to be insolvent, the value of your assets must be less than the total amount of debts just prior to the forgiveness. Farm debts are excluded, as are non-recourse loans. When a borrower defaults on a non-recourse loan, the lender's only remedy is to repossess the property that it secures; it cannot sue the borrower directly.