Mortgage Forgiveness Debt Relief Act Expiration: What It Means for Homeowners Facing Short Sales and Foreclosure

Originally passed in 2007 during the housing crisis, the Mortgage Forgiveness Debt Relief Act (MFDRA) amended the Internal Revenue Code to exclude forgiven mortgage debt from a taxpayer's gross income on their primary residence. Normally, when a lender forgives debt, the IRS treats the forgiven amount as taxable income. Under the MFDRA, up to $2 million of forgiven mortgage debt ($1 million for married filing separately) could be excluded from income.

This meant that if you completed a short sale and your lender forgave $100,000 of your remaining mortgage balance, you would not have to pay income tax on that $100,000. The provision covered debt forgiven in connection with a foreclosure, short sale, or loan modification on a principal residence.

The MFDRA was originally set to expire at the end of 2012, but Congress extended it multiple times over the following years. The provision was retroactively extended several times, sometimes after gaps in coverage had already occurred. Most recently, the Consolidated Appropriations Act of 2021 extended the MFDRA through December 31, 2025.

With the expiration at the end of 2025 and no subsequent renewal, the exclusion for forgiven mortgage debt has now lapsed. Unless Congress acts retroactively, forgiven mortgage debt on primary residences is once again treated as taxable income by the IRS.

The expiration of the MFDRA means that homeowners who complete a short sale, go through foreclosure, or sign a deed-in-lieu agreement in 2026 may now receive a Form 1099-C (Cancellation of Debt) from their lender. The forgiven debt amount listed on that form could be treated as ordinary income by the IRS.

For example, if you owe $300,000 on your mortgage and your home sells in a short sale for $200,000, the lender may forgive the remaining $100,000 difference. Without the MFDRA protection, that $100,000 could be added to your taxable income for the year. Depending on your tax bracket, that could mean a federal tax bill of $10,000 to $37,000 or more, plus potential state taxes.

Even with the MFDRA expired, there is still a potential way to avoid paying tax on forgiven debt: the insolvency exception. Under IRS rules, if you were insolvent immediately before the debt was forgiven, the forgiven debt may be excluded from your income up to the amount by which you were insolvent.

You are considered insolvent if your total liabilities exceed the fair market value of your total assets. This test includes everything you own, not just your home. For many homeowners facing foreclosure, this exception may apply since their financial distress often means their debts far exceed their assets.

If you are considering a short sale, facing foreclosure, or thinking about a deed-in-lieu of foreclosure, you need to plan ahead for potential tax consequences. Here are the steps we recommend:

• Consult a tax professional

  A CPA or tax attorney can evaluate your specific situation, determine whether the insolvency exception applies, and help you file Form 982 if needed.

• Keep all financial records

  Document your assets, liabilities, and income at the time of the transaction. This will be essential for proving insolvency or responding to an IRS inquiry.

• Understand your lender's reporting obligations

  Lenders are required to issue a 1099-C when they forgive $600 or more of debt. Be prepared to receive this form and address it on your tax return.

• Work with an experienced real estate professional

  Randy Swihart has over 40 years of experience in REO and distressed sales and can help you understand all of your options before you make a decision.

It is possible that Congress may retroactively extend the Mortgage Forgiveness Debt Relief Act, as it has done several times before. However, there is no guarantee, and homeowners should not rely on a potential future extension when making decisions today. Planning as if the current rules will remain in place is the safest approach.

If Congress does extend the provision retroactively, any tax you have already paid on forgiven debt could be refunded through an amended tax return. But waiting and hoping for legislative action is a risky strategy when your financial future is on the line.