But whenever a lender forgives a debt, the cancelled debt becomes part of your taxable income -- which could make for a very unpleasant surprise at tax time.

 

Generally cancelled debt refers to any money you have borrowed from a lender that you do not have to repay because the lender "forgave" the amount owed. For example, if you owe $500,000 on your home and the house is sold in a short-sell for $400,000 and the bank forgives the remaining $100,000 owed on the loan, that $100,000 is cancelled debt.

 

Lenders are required to file a 1099-C Cancellation of Debt form whenever they forgive a debt greater than $600. This form is filed with the IRS and a copy is sent to the borrower. The form will show the amount of cancelled debt as well as any interest forgiven on the debt. In some instances, interest from cancelled debt may not have to be included as taxable income. If you choose to repay a portion of a cancelled debt, you may be able to file a claim for a refund of any taxes you paid on the debt.

 

There are some limited, but very useful, exclusions and exceptions to the cancelled debt/income rule. The following types of cancelled debt are not taxable:

Debt cancelled in connection with a home mortgage refinancing or home foreclosure also may be excluded from taxable income. In 2007, Congress passed the Mortgage Forgiveness Debt Relief Act to help protect homeowners already in financial straits from harsh tax consequences. The Act currently is valid through 2012.

 

The federal law applies to cancelled debt from foreclosures and mortgage refinancing in connection with the homeowners' primary residence. In the case of refinancing, only the amount up to the old mortgage principal balance immediately before the refinance is eligible for the exclusion. The maximum amount of debt that may be exempt is $2 million. For married couples filing separate tax returns, the maximum is reduced to $1 million.

 

The Mortgage Forgiveness Debt Relief Act does not apply to second homes, business properties or rental properties. It also does not apply to other types of cancelled debt, like credit cards or car loans.

 

Just because a cancelled debt is excluded from your taxable income does not mean you do not have to report the cancelled debt to the IRS. The excluded income also could have other tax consequences. It is important to consult an experienced tax advisor for information on the potential impact forgiven debt may have for your specific situation.