If a creditor decides that a debt can't be collected, it may write off the debt and stop collection efforts. That's great news if you're a debtor and money is tight, but it's not the end of the story. The Internal Revenue Service views that discharged debt as income, and wants you to pay a tax on the money. (Confused? Think of it this way. "Income" is anything you receive that has value. Sometimes it's money and sometimes it's goods or services. If you charge $1,000 to a credit card, you've received $1,000 of value. If you don't pay that debt, you essentially "earned" $1,000 of income.)
In the wake of the recession and real estate crisis, taxpayers who lost their homes to foreclosure were getting hit by big tax bills, since mortgage companies were forgiving large loans. In response, Congress passed the Mortgage Forgiveness Debt Relief Act of 2007, which is in effect through the end of 2013.
According to the IRS:
"The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief...Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home's value or the taxpayer's financial condition."
This may seem straightforward, but can get complicated if there's disagreement about whether the home was your "principal residence," or if the forgiven debt was more than $2 million. Mistakes can be costly, since they could result in IRS fines and penalties. A tax lawyer can help you understand the laws and ensure that you pay the IRS what you owe.
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