- Only homes that were used as a primary residence are eligible for the debt to be canceled without having to pay taxes. If your home was just a vacation home or an investment property, you will have to pay taxes on canceled debt after losing the home. If you rented out your home some of the time but lived in it as your primary residence for at least two of the five years before foreclosure, it qualifies as your primary residence for tax purposes.
- Only debt that was due to the purchase, repair or improvement of a home qualifies to be forgiven without paying taxes. Therefore, if part of your mortgage or home equity line of credit was used for other purposes, such as consolidating credit card debt, paying off student loans or buying a car, you will have to pay taxes on this forgiven debt. To calculate how much debt you can exclude from taxes, subtract the market value of your home at the time of the sale from the amount of all mortgages to find out your forgiven debt. Then subtract the amount of debt you had that was for purposes unrelated to your home to calculate your tax-free forgiven debt.
- The Mortgage Forgiveness Debt Relief Act only applies to the first $2 million of forgiven debt or the first $1 million for married people filing separately. Therefore, if you had more than $2 million of debt canceled after losing your very expensive home, you will owe taxes on the amount above $2 million that was canceled.
- Fill out Internal Revenue Service Form 982, and attach it to your federal tax return. In particular, you will need to check Box E in Question 1 and include the amount qualified to be excluded from income in Question 2. If you had any debt that is not excluded from income taxes -- such as forgiven home equity debt not used for home acquisition, repair or improvement -- report this as income on Line 21 of IRS Form 1040.