The Qualifications for Mortgage Forgiveness

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Mortgage forgiveness occurs when the mortgage lender forgives some or all loan debt that you owe. This can occur when you have either modified your loan using a loan modification program or lost your home in a foreclosure. Up until 2007, the forgiven debt was taxed as income, adding to the distressed homeowner's financial burden. But under the Mortgage Forgiveness Debt Relief Act of 2007, the forgiven debt has been rendered tax-free. This law will remain in effect until December 31, 2012. If it's not extended, homeowners who lost their homes after that date will have to pay taxes on their forgiven mortgage debt.

Understanding Mortgage Forgiveness

When a mortgage lender sells you a mortgage, it expects that you will eventually pay it back. This is why it does not want to have to forgive your debt unless it feels that there is no way you will possibly be able to repay it. Since the situation does not benefit you or the lender, this is usually the option of last resort. The lender will try to work with you, offering to let you refinance or modify your loan. The loan modification program will reduce the amount you have to pay on a monthly basis, but it may wind up increasing the amount you will have to pay overall.

If your attempts to repay your loan fail, and you stop making mortgage payments, the lender has a right to initiate foreclosure proceedings against you. First, the lender sends out the notice that you are in default. The notice will give you one last chance to avoid foreclosure, offering to drop the proceedings if you resume making mortgage payments by the date specified on the notice. If you don't respond, the lender can go to court and ask for the permission to repossess your home. You have a right to challenge the lender in court. If those challenges fail, though, or if you don't challenge the foreclosure at all, the lender will take your house and sell it in effort to try to recoup some of the money it lost when you stopped paying your mortgage.

Once the mortgage lender repossesses your home, your mortgage repayment obligations are canceled. Since this is the money that you will no longer have to spend, it is considered a gain under the US tax law, and as such, it is taxed as income. The Mortgage Forgiveness Debt Relief Act of 2007 allows you to avoid paying that portion of your income tax if you meet certain requirements.

Qualifying for Mortgage Debt Tax Relief

If the mortgage you owed was less than $2 million, you don't have to pay any taxes on it. If you owe more than that, you will have to pay taxes on anything that remains when you subtract the $2 million. If you are married and you file a tax return separately from your spouse, only up to $1 million will be forgiven. Furthermore, the law applies only to mortgage owed on your primary home--the home where you live for most of the calender year. Second homes, vacation homes and rental properties don't qualify. 

Loan Forgiveness and Tax Forms

In order to claim mortgage debt tax relief, you must fill out IRS Form 982. You must attach copies of the documents related to the foreclosure and the amount you still owe. Once you have completed Form 982, you will have to write in the total on Line 21 of IRS Form 1040.