May 5, 2020
The Tax Treatment of Canceled Mortgage Debt
Recent data indicate that the economy is weakening and
temporary exclusion for qualified canceled mortgage debt.
that labor markets are under a great deal of strain as fallout
This was intended to prevent homeowners who were
from the COVID-19 outbreak continues. The corresponding
granted principal reductions, or who entered into short sale
drop in incomes is causing financial hardship for some
agreements, from owing tax on top of existing financial
homeowners as they struggle to make timely mortgage
distress. The provision was originally effective for debt
payments. Included in the broader third round of economic
discharged before January 1, 2010. The exclusion for
relief known as the Coronavirus Aid, Relief, and Economic
canceled mortgage debt was subsequently extended several
Security (CARES) Act (P.L. 116-136) were temporary
times, most recently by the Further Consolidated
forbearance for federally backed single-family and
Appropriations Act, 2020 (P.L. 116-94). That law extended
multifamily mortgages and a temporary foreclosure
the exclusion for canceled mortgage debt through the end of
moratorium for federally backed single-family mortgages.
2020.
These provisions are discussed in CRS Insight IN11334,
Mortgage Provisions in the Coronavirus Aid, Relief, and
The exclusion applies to qualified residential indebtedness,
Economic Security (CARES) Act, by Katie Jones and
which is defined as debt, limited to $2 million ($1 million if
Andrew P. Scott.
married filing separately), incurred in acquiring,
constructing, or substantially improving the taxpayer’s
Once these temporary efforts to assist homeowners expire,
principal residence that is secured by such residence. It also
there may be an increased number of home foreclosures,
includes refinancing of this debt, to the extent that the
mortgage defaults, or mortgage modifications barring
refinancing does not exceed the amount of refinanced
additional relief efforts. Attempts to resolve mortgage
indebtedness (e.g., cash-out refinance). Taxpayers are
indebtedness concerns may result in cancellation of debt,
required to reduce the basis in their principal residence by
which can have important tax consequences. This In Focus
the amount of the excluded income. The provision does not
provides a brief overview of the tax treatment of canceled
apply if the discharge was on account of services performed
mortgage debt.
for the lender or any other factor not directly related to a
decline in the residence’s value or to the taxpayer’s
Cancellation of Indebtedness Income
financial condition.
Historically, if a lender forgives or cancels mortgage debt
(and most other debts), tax law has treated the amount of
An Example
canceled debt as a cancellation of debt income (CODI)
An example may be helpful in demonstrating the tax
subject to ordinary income tax rates. Section 108 of the
implications when CODI is not excluded from taxation.
Internal Revenue Code (IRC) contains two exceptions that
Consider a homeowner with a current mortgage balance of
are particularly relevant in the case of canceled home
$200,000. The lender agrees to a loan restructuring that
mortgage debt: a borrower may exclude canceled debt from
cancels $20,000 in debt and reduces the homeowner’s loan
gross income if (1) the debt is discharged in Title 11
balance to $180,000. The discharged debt, $20,000, is
bankruptcy; or (2) the borrower is insolvent (that is, has
income subject to tax if no exclusion applies (e.g., the
liabilities that exceed the fair market value of his or her
taxpayer is not insolvent). If a 24% marginal tax rate is
assets, determined immediately prior to discharge). These
assumed, then the homeowner would have a tax liability of
exceptions are permanent tax provisions.
$4,800 ($20,000 multiplied by 24%) from the debt
cancelation.
In response to the housing market turmoil of the late 2000s,
some lenders made efforts to work with borrowers and
Alternatively, the home could have been sold as a result of
avoid foreclosure. Examples of these efforts included
foreclosure along with a lender agreement to cancel the
principal reductions, which allow the homeowner to remain
remaining debt. If the home were to sell for $180,000 then
in the home, and “short sale” transactions. In a short sale,
this would result in $20,000 of remaining debt. The $20,000
the property is listed for sale and the lender agrees to
of discharged debt would be income assuming no exclusion
forgive any debt outstanding that the sale price does not
applies, and also still assuming a 24% marginal tax rate,
cover. Both principal reductions and short sales often
would generate the same tax liability as in the previous
resulted in canceled mortgage debt and, as a result, CODI
scenario. This is in addition to any taxes the taxpayer may
subject to tax. Other efforts, such as extending the term of
owe on the gain from the sale of the house.
the loan or interest rate reductions, however, generally did
not result in CODI.
Policy Issues
Rationales put forth when the exclusion provision was
In December 2007 the Mortgage Forgiveness Debt Relief
originally enacted included minimizing hardship for
Act of 2007 (P.L. 110-142) was enacted and provided a
distressed households, lessening the risk that nontax
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The Tax Treatment of Canceled Mortgage Debt
homeownership retention efforts would be thwarted by tax
before its expiration. A permanent extension, however,
policy (e.g., short sales), and assisting in the recovery of the
would have a cost in terms of reduced revenue for which
housing market and, in turn, the overall economy.
the Joint Committee on Taxation (JCT) would provide an
Arguably, these same rationales still apply in the current
estimate. An argument could also be made that such an
environment.
extension would introduce a permanent discrepancy in the
tax code between how different types of debt are treated.
An argument against the exclusion that was made at the
time the provision was first being debated was that it makes
Eligible Debt Limits
debt forgiveness more attractive for homeowners, which
Congress could consider adjusting the eligible amount of
could encourage homeowners to be less responsible about
debt that qualifies for the exclusion. The exclusion is
committing to and fulfilling debt obligations. Given that the
currently limited to $2 million ($1 million if married filing
current concerns over default and foreclosure are being
separately) of qualified mortgage debt. Increasing the limit
driven by the fallout from a global pandemic, this view may
would likely increase the revenue loss associated with the
not be held by as many people as it was during the Great
exclusion, whereas decreasing the limit would have the
Recession.
opposite effect. Decreasing the exclusion limit might also
reduce the benefit to upper-income taxpayers who are
Another concern some had at the time involved the equity
subject to higher marginal tax rates and thus receive a
of the provision. A standard of fairness frequently invoked
greater benefit in terms of tax savings per dollar of
by public finance economists in evaluating tax policies is
exclusion. For example, individuals in the 22%, 32%, and
“horizontal equity”—a standard that is met when similarly
37% tax brackets benefit differently from the same $20,000
situated taxpayers pay the same amount of tax. Like other
of forgiven mortgage debt—$4,400, $6,400, and $7,400 in
tax exclusions, excluding forgiven debt—a unique type of
reduced taxes, respectively. Arguably, policymakers could
income—violates the standard of horizontal equity.
set the debt limits to those of the mortgage interest
deduction, which are, depending on when the home was
As the exclusion for canceled mortgage debt is set to expire
purchased, $1 million ($500,000 if married filing
after 2020, Congress may choose to extend the exclusion
separately) or $750,000 ($375,000 if married filing
again, either temporarily or permanently, or may allow it to
separately).
expire. If Congress decides to extend the exclusion it may
also consider modifications to the provision. Which
Income Limits
modifications, if any, are enacted will depend on
Income limits could be enacted and the exclusion made
policymakers’ goals.
unavailable to those households with income above the
ceiling. It would seem that income and foreclosure would
Temporary vs Permanent Exclusion
be correlated because lower-income taxpayers may be more
One consideration for Congress is whether the exclusion
financially constrained than higher-income taxpayers. But
provision should be temporary or permanent. The exclusion
given the severity of across-the-board financial distress this
has been part of tax law since 2007, but its extension has
latest economic downturn could cause, the correlation could
often happened retroactively, creating some uncertainty and
be weaker than in past downturns. Regardless, it could be
anxiety both for impacted homeowners and for lenders and
argued that household income is not relevant if the
servicers, which may influence the options they present to
exclusion’s objective is to provide relief to households in
homeowners. Extending the exclusion from 2021 (or
financial distress. This option could reduce the revenue loss
further) would presumably help alleviate the concerns of
associated with the provision, but would add complexity to
distressed homeowners.
the administration and tax filing process
Another option would be to make the exclusion of forgiven
Mark P. Keightley, Specialist in Economics
mortgage debt permanent. It would also address an inequity
that some perceive exists because borrowers in distress after
IF11535
the provision’s expiration are treated differently than those


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The Tax Treatment of Canceled Mortgage Debt


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