Does a Person Have to Pay Tax on Their Forgiven Mortgage Debt?

Does a Person Have to Pay Tax on Their Forgiven Mortgage Debt?

The big question from many short sale sellers in 2019 is, “Will I have to pay income tax on my forgiven debt now that the IRS mortgage forgiveness act is expired?”

Here’s some background:  Unless there is an exemption, the Internal Revenue Service has historically treated forgiven debt as taxable income.  That means that people with forgiven debt (such as from a mortgage, credit card, or installment loan) would pay tax as if the forgiven amount were ordinary income.  To give homeowners some relief, President George W. Bush signed the Mortgage Forgiveness Debt Relief Act (MFDRA) of 2007 into law, allowing short sale sellers of their principal residence to pay no income tax as long as they submitted IRS Form 982 with their federal tax return.  The original MFDRA was good until December 31, 2009.  President Barack Obama then signed several extensions through 2016.  President Donald Trump signed a one year extension that was good through December 31, 2017. 

There is currently one bill in the House of Representatives for it to be extended to cover short sales that happened in 2018 and 2019, but as of the date of this article it was not advanced.  I do not think it will be enacted into law retroactively.

So, what can a person do to avoid being hit with higher taxes after a short sale? Thankfully, there is another way to avoid tax on debt forgiveness that applies to many short sale sellers.  Forgiven debts do not need to be counted as taxable income if the debt was canceled in a bankruptcy case, or if the person is insolvent, or if the forgiven debt was intended as a gift.  Certain business or farm property may also qualify.

The most relevant option for short sale sellers is the insolvency exclusion.  It applies not just to principal residences but in some cases to those with forgiven debt from investment properties and vacation homes.

To be considered insolvent, the person’s liabilities must exceed the fair market value of their assets.  The IRS code states, “A taxpayer is insolvent when his or her total liabilities exceed his or her total assets.  The forgiven debt may be excluded as income under the ‘insolvency’ exclusion.  Normally a taxpayer is not required to include forgiven debts in income to the extent that the taxpayer is insolvent.  The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness.  If you believe you qualify for any of these exceptions, see the instructions for Form 982.” 

If the seller’s debts and liabilities exceed their assets by more than the amount of debt forgiven, then they do not have to pay income tax on the forgiven amount.  Below is an example:

Susanna’s home is worth $200,000, but her mortgage debt is $300,000.  When the house is sold for $200,000, Susanna’s lender receives $175,000 and they forgive the remaining $125,000. 

$200,000         Sale price.

– $25,000         Real estate commission and closing costs.

$175,000         Amount Susanna’s bank receives on the $300,000 balance.

$125,000         Amount of debt the bank forgives.  This is sent via a 1099-C to Susanna.

At first, Susanna panics because she fears that her income will increase by $125,000, thereby pushing her into a 32% tax bracket and increasing her tax bill by up to $41,000.  However, Susanna’s accountant performs some calculations to see if she qualifies for the insolvency exclusion:

    $225,000         Assets ($200,000 house plus $10,000 in savings and a $15,000 car)

– $350,000        Liabilities ($300,000 mortgage plus $50,000 in credit card debt)

     $125,000         Insolvency amount

Susanna’s accountant states that the insolvency of $125,000 and the 1099-C of $125,000 are a wash.  They cancel each other out.  Therefore, Susanna does not owe any tax on the canceled debt.

Let’s imagine that Susanna had an insolvency amount of $100,000 instead of $125,000.  Then she would have to pay income tax on the remaining $25,000 of forgiven debt. 

This article is not intended as tax advice.  I am not an accountant nor am I a tax attorney.  I suggest you consult with your tax advisor prior to your short sale and then after the sale.  Your tax advisor can examine your particular situation and guide you appropriately. 

Tai DeSa is a graduate of The Wharton School of the University of Pennsylvania.  He became a full-time real estate investor in 2004 after serving in the U.S. Navy.  Tai has made colossal mistakes in investing (and learned some things along the way).  He has helped hundreds of homeowners avoid foreclosure through successful short sales. Check out Tai’s books on short sales on Tai may be available for coaching and speaking engagements on a variety of real estate topics.  Send an email to

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