Forgiven Mortgage Debt May Increase Homeowners’ Income Tax Liability Starting Next Year

The cancellation of indebtedness generally produces income for federal and state income tax purposes. But as LA Times writer Jim Puzzanghera explains, "in 2007, Congress enacted the Mortgage Forgiveness Debt Relief Act to
give struggling homeowners a break. If the debt is forgiven because of a
drop in a home's value or a decline in the owner's financial condition,
up to $2 million of the relief for couples filing jointly is exempted
from federal taxes." The tax break originally was set to expire at the end of 2010, but Congress extended it through the end of 2012. So, unless Congress acts again, homeowners who receive debt reduction from their banks in an effort to avoid foreclosure–for instance, as part of the multi-billion dollar government settlement with the nation's five largest mortgage debt servicers–could be handed a large, and unexpected, tax bill in 2013 and beyond. (Much of the relief under the government settlement will come in future years.)

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