The IRS requires taxpayers to pay tax on forgiven debt. This means that whenever a lender cancels or forgives money that you owe, you typically have to pay taxes on that amount. However, for 2013, the IRS is making a special exception for cancelled home mortgage debt.
You may exclude the cancelled debt amount from your income if the cancelled debt was on your main residence and you used the loan to buy, build or renovate it. Even if the lender cancelled only a part of the mortgage, you can still exclude that amount from your income.
If your debt amount of $600 or more is cancelled, make sure that you receive Form 1099-C, Cancellation of Debt, from the lender. The 1099-C should include the amount of debt cancelled along with other important information regarding the debt and its cancellation.
You may also use the exclusion if you use the proceeds from refinancing mortgage to buy, build or make substantial improvements to your main residence. This exclusion does not include cancelled mortgage debt on second homes, rental and business property, credit card debt or car loans.
To have the debt excluded, you may want to check if you are eligible for the Home Affordable Modification Program. Even if the amount of debt has been cancelled in a foreclosure, you may still be eligible for the exclusion.
If you fulfil the requirements for exclusion, you need to report the excluded debt by filing Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness along with your tax return. For electronic filing of your tax return, you can use the IRS free tax filing service called e-file available on the IRS website.
If you have taken a loan for buying a main residence and you are paying interest on it, you may be eligible to use the Mortgage Interest Credit.