A forgiven loan is a cancelled or reduced debt. Forgiveness happens when a lender, an event or an action lowers or wipes away what you otherwise would be required to pay back. Lenders reduce mortgage balances with discounts, refinancing or repossession of your home. You can usher your own loan forgiveness through bankruptcy. Cancellation of a home loan can relieve your debt burdens and give you a fresh start, but it may also raise your income tax bill.
Discounts and Modifications
A lender partially cancels a debt when it discounts or reduces the balance due if you repay the debt earlier than required. Forgiveness also comes through refinancing -- or a change of terms -- that lowers the principal balance. If a bank merely gives you more time to pay off your loan or rolls your principal over into another loan with a new maturity date, your loan is not forgiven, so you must still repay what you borrowed.
Bankruptcy can wash away an underwater mortgage -- a loan for which you owe more than the home is worth. In a bankruptcy, the lender gets paid up to your home's value. The remainder of the loan is treated as unsecured. Bankruptcy discharges that remaining balance. The bank cannot make you pay it back or sue you, and you no longer owe the bank. You don't pay taxes on the debt discharged in bankruptcy.
Foreclosures and Repossessions
Your lender may forgive your debt by taking and reselling your home if you miss payments. Forgiveness occurs if the lender gets less in the foreclosure or the home is worth less than you owe. If you were personally liable, what you still owed is canceled debt income (unless the tax law excludes it). If not, treat the debt as what you would have received from selling the home. You may be taxed on the gain if the canceled debt is more than what the home costs. Normally, this will not happen if you borrowed money to buy the home.
Seller's Price Drop
A seller might "loan" you the purchase price by letting you pay in installments. If the seller drops the price after you buy it, the amount that you must pay back is lowered. This type of forgiveness does not create taxable debt cancellation income if you are not bankrupt or on the verge of it. However, you must decrease the cost, or basis, of your home by the after-purchase discount. If you sell the home, you may have to pay taxes on the profit.
Normally, canceled debt is taxed as income because it is money you keep. You didn't pay tax when you got the loan because you originally promised to pay it all back. However, you are not taxed on canceled debt on your main home if it was forgiven between Jan. 1, 2007, and Dec. 31, 2012. The "Mortgage Forgiveness Debt Relief Act" allows you to shelter up to $2 million of canceled debt ($1 million if you are married but file a separate return). However, this law applies only to a mortgage on your principal home. You get no relief for a second home. Forgiveness by bankruptcy or as a gift is not taxed, even if the mortgage went with a second home.
- Internal Revenue Service: Publication 4681: Canceled Debts, Foreclosures, Repossessions and Abandoments (for Individuals)
- Internal Revenue Service: Tax Topics: Topic 431: Canceled Debt: Is it Taxable or Not?
- Internal Revenue Service: Publication 544: Sales and Other Dispositions of Assets
- Internal Revenue Service: Individuals: The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
- Internal Revenue Service: Home Foreclosure and Debt Cancellation
- Federal Trade Commission: Facts for Consumers: Mortgage Payments Send You Reeling? Here's What to Do
- Making Home Affordable: Home Affordable Modification Program
- State of California: Franchise Tax Board: Mortgage Forgiveness Debt Relief Extended: Updated 4/30/10
Christopher Raines enjoys sharing his knowledge of business, financial matters and the law. He earned his business administration and law degrees from the University of North Carolina at Chapel Hill. As a lawyer since August 1996, Raines has handled cases involving business, consumer and other areas of the law.