If you owe a debt to a bank or any other creditor and they agree to forgive or reduce the balance of the debt, the canceled amount of the debt may be taxed by the Internal Revenue Service.
The Mortgage Debt Relief Act of 2007 generally allows IRS taxpayers to exclude income from the reduced debt on their principal place of residence. IRS taxpayers who were able to reduce debt owed their home through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, may not be taxed on the amount of the canceled debt.
Up to $2 million of forgiven debt is eligible for this IRS income tax exclusion ($1 million if married filing separately). The tax exclusion does not apply if the debt forgiveness is due to services performed, trades or offsets with the lender or any other reason which is not directly related to a decline in real estate value of the taxpayer’s home or their changed financial circumstance.