The Mortgage Forgiveness Debt Relief Act of 2007 allows individuals to exclude from gross income a discharge of qualified principal residence indebtedness (defined below). This exclusion applies to discharges made after 2006 and before 2010. Additionally, the basis of the principal residence must be reduced (but not below zero) by the amount excluded from gross income. To claim the exclusion, you must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), with your tax return.
Qualified principal residence indebtedness
This is a mortgage you took out to buy, build, or substantially improve your principal residence. It also must be secured by your principal residence. If the amount of your original mortgage is more than the cost of your principal residence plus the cost of any substantial improvements, only the debt that is not more than the cost of your principal residence plus improvements is qualified principal residence indebtedness. Any debt that is secured by your principal residence you use to refinance qualified principal residence indebtedness is treated as qualified principal residence indebtedness, but only up to the amount of the old mortgage principal just before the refinancing. Any additional debt you used to substantially improve your principal residence is also treated as qualified principal residence indebtedness.
Principal residence
Your principal residence is the home where you ordinarily live most of the time. You can have only one principal residence at any one time.
Amount eligible for the exclusion
The maximum amount you can treat as qualified principal residence indebtedness in $2 million ($1 million if married filing separately). You cannot exclude from gross income discharge of qualified principal residence indebtedness if the discharge was for services performed for the lender or on account of any other factor not directly related to a decline in the value of your residence or to your financial condition.
Ordering rule
f only a part of a loan is qualified principal residence indebtedness, the exclusion applies only to the extent the amount discharged exceeds the amount of the loan (immediately before the discharge) that is not qualified principal residence indebtedness. For example, assume your principal residence is secured by a debt of $1 million, of which $800,000 is qualified principal residence indebtedness. If your residence is sold for $700,000 and $300,000 of debt is discharged, only $100,000 of the debt discharged may be excluded (the $300,000 that was discharged minus the $200,000 of nonqualified debt).
