J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return

31.10 Restructuring Mortgage Debt

Rather than foreclose on a mortgage, a lender (mortgagee) may be willing to restructure the mortgage debt by cancelling either all or part of the debt. As a borrower (mortgagor), do not overlook the tax consequences of the new debt arrangement. If the lender agrees to a “workout,” under which part of your loan principal is reduced as part of a loan modification, or if you pay off the loan early in return for a “discount” that reduces the debt, and you keep the collateral, the reduction or discount is canceled debt, reportable as ordinary income (cancellation of debt income) unless an exception applies. This is true whether or not you are personally liable for the debt. However, if you were not personally liable (nonrecourse debt) and do not keep the collateral, there is no cancellation of debt income.

You may be able to avoid the ordinary income from the cancellation of the debt by taking advantage of one of the exclusions in the law, such as the exclusion for qualified principal residence indebtedness or the exclusions for insolvency, bankruptcy, qualified business real estate debt (see below), or qualified farm debt. Details of these exclusions are discussed in 11.8. The Jones example below illustrates the IRS approach to figuring insolvency upon a reduction of a nonrecourse debt.

In the case of partnership property, tax consequences of the restructuring of a third-party loan are determined at the partner level. This means that if you are a partner ...