In a mortgage foreclosure, short sale, or loan modification, there is always a hidden tax liability to worry about if the principal balance of the mortgage loan is forgiven or canceled.  If the value of the home is less than what is owed, the unpaid principal balance becomes a “deficiency” for which the homeowner remains personally liable.  In New Jersey, it is uncommon after a Sheriff Sale that the lender will pursue this claim. Instead, the lender will choose to cancel the balance due as uncollectible. That cancellation creates “COD Income” for the amount the borrower did not have to pay back. The borrower then gets a 1099 for the unpaid principal (but not interest) that they did not have to repay.

If the homeowner files a bankruptcy and receives a discharge before the lender write-off, there is no tax liability. For others in this situation, there was protection in place–called the Qualified Principal Residence Indebtedness [QPRI] Exclusion– but this expired at the end of 2017. This protection has now been extended to the end of 2020, and applies retroactively to 2018 and 2019. The taxpayer can exclude and avoid paying tax on up to $2 million of the canceled debt related to a drop in the value of the residence or the taxpayer’s financial condition. This applies only to a principal residence.

This is important information for anyone whose mortgage is in default or foreclosure, or in a short sale, or who has reported or paid tax on this type of income. Always consult with a CPA or qualified tax professional for advice. or who has reported or paid tax on this type of income. We are not qualified tax professionals, and readers should not rely on this article for tax advice.

Nevertheless, whenever a home mortgage is in or facing default, there are most likely other problems that need to be addressed. There, we can help.