The Tax Treatment of Canceled Mortgage Debt: What You Need to Know

The tax treatment of canceled mortgage debt has been a topic of significant interest, particularly in the aftermath of the housing market turmoil of the late 2000s and the Great Recession. When a lender forgives or cancels mortgage debt, it historically results in the amount of canceled debt being treated as cancellation of debt income (CODI), subject to ordinary income tax rates. However, there are exceptions and provisions in the Internal Revenue Code (IRC) that allow borrowers to exclude canceled mortgage debt from their gross income under specific circumstances. In this blog post, we'll provide an overview of the tax treatment of canceled mortgage debt and discuss some policy considerations.

 

Cancelation of Indebtedness Income (CODI)

CODI refers to the taxable income that arises when a lender forgives or cancels a portion of a borrower's mortgage debt. This income is generally subject to ordinary income tax rates. It's important to note that not all efforts by lenders to assist distressed borrowers result in CODI. Principal reductions and short sale transactions are examples of actions that often lead to canceled mortgage debt and, consequently, CODI. However, extending the loan term or reducing the interest rate typically do not result in CODI.

 

The Mortgage Forgiveness Debt Relief Act of 2007

In response to the housing crisis, the Mortgage Forgiveness Debt Relief Act of 2007 was enacted. This legislation provided a temporary exclusion for qualified canceled mortgage debt. The goal was to prevent homeowners who received principal reductions or entered into short sale agreements from owing additional taxes on top of their existing financial distress. Originally effective for debt discharged before January 1, 2010, this exclusion has been extended multiple times, most recently through the Consolidated Appropriations Act, 2021, which extended it through the end of 2025.

 

Key Features of the Exclusion

The exclusion for canceled mortgage debt applies to qualified residential indebtedness, which includes debt related to the acquisition, construction, or substantial improvement of the taxpayer's principal residence. The debt must be secured by the residence. Before P.L. 116-260, the exclusion was limited to $2 million ($1 million if married filing separately), but this limit has been reduced to $750,000 ($375,000 if married filing separately) for debt discharged after its enactment.

Refinanced mortgage debt can also be eligible for the exclusion, as long as the refinancing does not exceed the amount of refinanced indebtedness (e.g., cash-out refinance). Taxpayers are required to reduce the basis in their principal residence by the amount of the excluded income. The exclusion does not apply if the debt discharge is unrelated to a decline in the residence's value or the taxpayer's financial condition.

 

Policy Considerations

Several policy issues surround the exclusion of canceled mortgage debt. Some argue that it helps distressed households and supports homeownership retention efforts, especially during economic crises. However, others contend that it encourages homeowners to be less responsible about fulfilling their debt obligations, which could have unintended consequences.

As the exclusion is set to expire after 2025, Congress faces decisions about its future. They may choose to extend it temporarily, make it permanent, or allow it to expire. Each option has its implications, such as the potential impact on federal revenue and equity in the tax code.

 

Temporary vs. Permanent Exclusion

Congress must decide whether the exclusion should be temporary or permanent. Retroactive extensions have caused uncertainty, so a permanent extension could provide stability. However, it would also reduce federal revenue and introduce a long-term disparity in how different types of debt are treated in the tax code.

 

Eligible Debt Limits

Congress can adjust the eligible amount of debt that qualifies for the exclusion. Increasing the limit would benefit more taxpayers but result in greater revenue loss, particularly for upper-income individuals. Reducing the limit would have the opposite effect.

 

Income Limits

Another consideration is implementing income limits for eligibility, which would exclude households with income above a certain threshold. This could align with the exclusion's objective of providing relief to financially distressed households but would add complexity to tax administration.


The tax treatment of canceled mortgage debt is a complex issue with significant implications for both borrowers and the government. As the current exclusion is set to expire in 2025, policymakers will need to make important decisions about its future. Whether the exclusion is extended, modified, or allowed to expire, it will continue to be a subject of debate and scrutiny in the realm of tax policy.