Loan Modification

Tax Fact 4-Only Certain Mortgage Debt Qualifies For Exclusion

By Kent Anderson, Oregon Bankruptcy Attorney

Mortgage debt forgiveness is considered to be income unless it is excluded.  Principal residence debt has its own exclusion from income if it is cancelled or forgiven by the lender.  To ?qualify? it must be what is defined by the Internal Revenue Service as ?qualified principal residence debt?.  The debt must have been used to buy, build or substantially improve the principal residence of the taxpayer and the home must act as security for the debt.

With the substantial increase in home prices that occurred over the ten years beginning in 2000, many people sought to access this ?residential piggy bank? by refinancing their home.  Often, the funds borrowed in such a refinance were used to pay bills unrelated to the principal residence like credit card debt.  The IRS will not allow the use of that ?residential piggy bank? money for general consumer expenditures.  If the money is not spent on the principal residence, the taxpayer will not be permitted to exclude it from income if the debt gets cancelled.  If the money is used for some purpose other than buying, making a substantial improvement or building your home it is not ?qualified? for the exclusion allowed by the Mortgage Forgiveness Debt Relief Act of 2007. 

It is important to note that borrowing against a home does not create a tax liability in and of itself.  A taxpayer can borrow against a principal residence and use that money for any purpose.  However, if the debt is cancelled, that portion of the debt secured against the home and used for purposes other than paying off existing debt that is ?qualified? would constitute taxable income unless it is otherwise excluded.  

In most cases, if a home equity line of credit is cancelled in whole or in part, by foreclosure, short sale or restructuring, the amount cancelled or forgiven will be considered income in the year in which the cancellation occurred.  The Mortgage Forgiveness Debt Relief Act of 2007 will not exclude any portion of the home equity line of credit unless it too was used for substantial improvement of the home.  However, there are other exclusions that may apply.

Related posts:

1. Tax Fact 2-Mortgage Debt Forgiveness Exclusion Financial Limits
2. Tax Fact 1-The Mortgage Forgiveness Debt Relief Act of 2007
3. Tax Fact 3-Debt Cancelled through Mortgage Restructuring is Eligible

Full post as published by Mortgage Law Network on March 13, 2010 (boomark / email).