The Tax Treatment of Canceled Mortgage Debt

The Tax Treatment of Canceled Mortgage Debt

Updated January 14, 2021
The Tax Treatment of Canceled Mortgage Debt
Historically, if a lender forgives or cancels mortgage debt
(JCT) estimated this extension will reduce federal tax
(and most other debts), tax law has treated the amount of
revenues by $2.8 billion between 2021 and 2030.
canceled debt as a cancellation of debt income (CODI)
subject to ordinary income tax rates. Section 108 of the
The exclusion applies to qualified residential indebtedness,
Internal Revenue Code (IRC) contains two exceptions that
which is defined as debt, limited to $750,000 ($375,000 if
are particularly relevant in the case of canceled home
married filing separately), incurred in acquiring,
mortgage debt: a borrower may exclude canceled debt from
constructing, or substantially improving the taxpayer’s
gross income if (1) the debt is discharged in Title 11
principal residence that is secured by such residence. Prior
bankruptcy; or (2) the borrower is insolvent (that is, has
to P.L. 116-260 the exclusion was limited to $2 million ($1
liabilities that exceed the fair market value of his or her
million if married filing separately).
assets, determined immediately prior to discharge). These
exceptions are permanent tax provisions.
Eligible debt also includes mortgage debt resulting from a
refinancing, to the extent that the refinancing does not
Near the beginning of the housing downturn and Great
exceed the amount of refinanced indebtedness (e.g., cash-
Recession, Congress enacted a temporary provision that
out refinance). Taxpayers are required to reduce the basis in
provided distressed borrowers another option for excluding
their principal residence by the amount of the excluded
canceled mortgage debt. This provision has been extended a
income. The provision does not apply if the discharge was
number of times since its original enactment, most recently
on account of services performed for the lender or any other
by the Consolidated Appropriations Act, 2020 (P.L. 116-
factor not directly related to a decline in the residence’s
260), which extended it through the end of 2025. The latest
value or to the taxpayer’s financial condition.
extension also reduced the maximum amount of debt that
qualifies for the exclusion.
An Example
An example may be helpful in demonstrating the tax
This In Focus provides a brief overview of the tax treatment
implications when CODI is not excluded from taxation.
of canceled mortgage debt.
Consider a homeowner with a current mortgage balance of
$200,000. The lender agrees to a loan restructuring that
Cancelation of Indebtedness Income
cancels $20,000 in debt and reduces the homeowner’s loan
In response to the housing market turmoil of the late 2000s,
balance to $180,000. The discharged debt, $20,000, is
some lenders made efforts to work with borrowers and
income subject to tax if no exclusion applies (e.g., the
avoid foreclosure. Examples of these efforts included
taxpayer is not insolvent). If a 24% marginal tax rate is
principal reductions, which allow the homeowner to remain
assumed, then the homeowner would have a tax liability of
in the home, and “short sale” transactions. In a short sale,
$4,800 ($20,000 multiplied by 24%) from the debt
the property is listed for sale and the lender agrees to
cancelation.
forgive any debt outstanding that the sale price does not
cover. Both principal reductions and short sales often
Alternatively, the home could have been sold as a result of
resulted in canceled mortgage debt and, as a result, CODI
foreclosure along with a lender agreement to cancel the
subject to tax. Other efforts, such as extending the term of
remaining debt. If the home were to sell for $180,000 then
the loan or interest rate reductions, however, generally did
this would result in $20,000 of remaining debt. The $20,000
not result in CODI.
of discharged debt would be income, assuming no
exclusion applies. Still assuming a 24% marginal tax rate, it
In December 2007 the Mortgage Forgiveness Debt Relief
would generate the same tax liability as in the previous
Act of 2007 (P.L. 110-142) was enacted and provided a
scenario. This is in addition to any taxes the taxpayer may
temporary exclusion for qualified canceled mortgage debt.
owe on the gain from the sale of the house.
This was intended to prevent homeowners who were
granted principal reductions, or who entered into short sale
Policy Issues
agreements, from owing tax on top of existing financial
Rationales put forth when the exclusion provision was
distress. The provision was originally effective for debt
originally enacted included minimizing hardship for
discharged before January 1, 2010.
distressed households, lessening the risk that nontax
homeownership retention efforts would be thwarted by tax
The exclusion for canceled mortgage debt was subsequently
policy (e.g., short sales), and assisting in the recovery of the
extended several times, most recently in the Consolidated
housing market and, in turn, the overall economy.
Appropriations Act, 2020 (P.L. 116-260), which extended it
Arguably, these same rationales still apply in the current
through the end of 2025. The Joint Committee on Taxation
environment.
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The Tax Treatment of Canceled Mortgage Debt
An argument against the exclusion that was made at the
increase the federal deficit. An argument could also be
time the provision was first being debated was that it makes
made that such an extension would introduce a permanent
debt forgiveness more attractive for homeowners, which
discrepancy in the tax code between how different types of
could encourage homeowners to be less responsible about
debt are treated.
committing to and fulfilling debt obligations. Given that the
current concerns over default and foreclosure are being
Eligible Debt Limits
driven by the fallout from a global pandemic, this view may
Congress could consider adjusting the eligible amount of
not be held by as many people as it was during the Great
debt that qualifies for the exclusion. The exclusion is
Recession.
currently limited to $750,000 ($375,000 if married filing
separately) of qualified mortgage debt. Increasing the limit
Another concern some had at the time involved the equity
would likely increase the revenue loss associated with the
of the provision. A standard of fairness frequently invoked
exclusion, whereas decreasing the limit would have the
by public finance economists in evaluating tax policies is
opposite effect. Prior to P.L. 116-260 the exclusion was
“horizontal equity”—a standard that is met when similarly
limited to $2 million ($1 million if married filing
situated taxpayers pay the same amount of tax. Like other
separately).
tax exclusions, excluding forgiven debt—a unique type of
income—violates the standard of horizontal equity.
The new lower eligible debt limits reduce the benefit to
upper-income taxpayers, who generally have larger
As the exclusion for canceled mortgage debt is set to expire
mortgages and are subject to higher marginal tax rates. For
after 2025, Congress may choose to extend the exclusion
example, individuals in the 22%, 32%, and 37% tax
again, either temporarily or permanently, or may allow it to
brackets benefit differently from the same $20,000 of
expire. If Congress decides to extend the exclusion it may
forgiven mortgage debt—$4,400, $6,400, and $7,400 in
also consider modifications to the provision. Which
reduced taxes, respectively. The current debt limits also
modifications, if any, are enacted will depend on
match those that apply for purposes of the mortgage interest
policymakers’ goals.
deduction (if the mortgage was originated after December
15, 2017).
Temporary vs. Permanent Exclusion
One consideration for Congress is whether the exclusion
Income Limits
provision should be temporary or permanent. The exclusion
Income limits could be enacted and the exclusion made
has been part of tax law since 2007, but its extension has
unavailable to those households with income above the
often happened retroactively. Retroactive extensions create
ceiling. It would seem that income and foreclosure would
some uncertainty and anxiety both for impacted
be correlated because lower-income taxpayers may be more
homeowners and for lenders and servicers, which may
financially constrained than higher-income taxpayers in
influence the options they present to homeowners. The
times of economic weakness, though this correlation could
most recent multiyear extension of the exclusion to 2025
currently be weaker than in past downturns. Regardless, it
will presumably help alleviate the concerns of more
could be argued that household income is not relevant if the
distressed homeowners and provide more certainty.
exclusion’s objective is to provide relief to households in
financial distress. This option could reduce the revenue loss
Another option would be to make the exclusion of forgiven
associated with the provision, but would add complexity to
mortgage debt permanent. This would also address an
the administration and tax filing process
inequity that some perceive exists because borrowers in
distress after the provision’s expiration are treated
Mark P. Keightley, Specialist in Economics
differently than those before its expiration. A permanent
extension, however, would reduce federal revenue and
IF11535

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The Tax Treatment of Canceled Mortgage Debt

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https://crsreports.congress.gov | IF11535 · VERSION 2 · UPDATED