A reader got a big break on his mortgage. Now he faces a big tax bill.

3 minute read

Question: I entered into a loan modification five years ago under HARP. The modification was not honored by my lender, and I had to sue. The result of the suit was my lender reduced the principal of my loan by $115,000, and they sent me a form called 1099-C. Do I really have to pay taxes on this?William in California

Howard Dvorkin, Debt.com chairman and CPA, responds…

HARP stands for Home Affordable Refinance Program, and since it launched in 2009, it’s been the government’s most popular program for refinancing mortgages. Why? Because HARP is designed for homeowners who are “underwater” – meaning they owe more on their mortgages than their homes are worth.

There are a bunch of rules for qualifying – loan-to-value ratio must be 80 percent, etc. – but what’s important for William and other HARP participants to know is this: Yup, taxes can become an issue.

Canceled debt is considered income

Like every other government program, complications abound. So I consulted two other financial experts who have sharp insights into William’s question.

“In many cases, when a lender cancels a portion — or all — of an outstanding balance, you usually have to consider that canceled debt as income and report it on your tax return for the year in which the debt was canceled,” says Crissinda Ponder, Staff Writer at LendingTree. “However, there are instances when the canceled debt can be excluded from your taxable income. One of those possible exclusions is a loan modification on your primary home. Since the principal balance on your mortgage has been reduced, you may qualify to exclude the $115,000 from your taxable income.”

So as you can see, the answer is: Yes, you must pay taxes – except when you don’t.

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When you do, you need the tax form William mentioned. The IRS calls it a 1099-C. If the canceled debt is at least $600, you must fill one out. This form lists important information about the canceled debt, including the amount owed and the cancellation date.

More information on form 1099-C

For more on the 1099-C, I consulted Jacob Dayan. He’s the co-founder of Community Tax, one of the best tax consulting firms I’ve ever worked with.

Dayan says if the property is your principal residence, and the forgiven loan principal was part of an “arrangement entered into before January 1, 2018, or earlier,” you likely will not need to pay tax on the $115,000.  But, he says…

If the home was not your principal residence, or the arrangement to forgive part of the loan principal was entered into in 2018 or 2019, then you likely owe income tax on the full $115,000. In general, there are no tax consequences for a loan. The borrower does not report the borrowed funds as income and does not report a deduction when the borrowed funds are paid back.  However, when a loan is forgiven the tax consequences change and the amount of forgiven debt is taxable to the borrower.

Why is it so complicated?

There’s a reason for all this back-and-forth. When the home mortgage crisis gripped the country starting in 2007, Congress enacted a provision to allow homeowners to exclude canceled debt as income (meaning no tax) as long as the canceled debt was for their principal residence.

But beginning in 2018, the government scaled back that provision significantly. For the tax years 2018 and beyond, Dayan says this: “To be excludable the discharged debt must, first, cover a mortgage on your principal residence and, second, the arrangement for the forgiven loan principal must be in writing and dated before January 1, 2018.”

He continues: “if the loan covered your principal residence and the agreement to forgive the principal occurred before January 1, 2018, you will be able to exclude the $115,000 on the 1099-C and pay no tax.  But if this was a rental property or second home, and the agreement to forgive the loan principal happened on January 1, 2018, or after, you will be stuck paying tax on the full $115,000.”

Consult a tax expert

If it confuses and confounds you, then my expert advice is this: Consult a tax expert like Jacob Dayan. In almost every case, you’ll save significantly more on your taxes than you’ll pay for the expert advice. As you can see, tax questions can easily get complicated. It often requires an expert to unspool the details – and find you the savings.

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About the Author

Howard Dvorkin, CPA

Howard Dvorkin, CPA

I’m a certified public accountant who has authored two books on getting out of debt, Credit Hell and Power Up, and I am one of the personal finance experts for Debt.com. I have focused my professional endeavors in the consumer finance, technology, media and real estate industries creating not only Debt.com, but also Financial Apps and Start Fresh Today, among others. My personal finance advice has been included in countless articles, and has appeared in the New York Times, the Washington Post, Forbes and Entrepreneur as well as virtually every national and local newspaper in the country. Everyone should have a reason for living that’s bigger than themselves, and besides my family, mine is this: Teaching Americans how to live happily within their means. To me, money is not the root of all evil. Poor money management is. Money cannot buy happiness, but going into debt always buys misery. That’s why I launched Debt.com. I’m glad you’re here.

Published by Debt.com, LLC