Is Mortgage Relief Taxable? Exclusions, Forms, and 2026 Rules

Mortgage relief is generally taxable. When a lender forgives part of what you owe on your home loan through a short sale, foreclosure, or principal reduction, the IRS treats the canceled balance as ordinary income for the year it was written off. The main shield homeowners relied on, the qualified principal residence indebtedness exclusion, expired on January 1, 2026. If you had a written forgiveness agreement in place before that date, you may still exclude up to $750,000 ($375,000 if married filing separately). Everyone else has to look to narrower relief: bankruptcy, or the insolvency exclusion, which only helps to the extent your debts exceeded your assets right before the cancellation.¹

Why Forgiven Mortgage Debt Is Treated as Income

You received something of value when the loan funded, and if you never have to pay part of it back, that benefit is economically the same as income. So the forgiven balance gets added to your gross income for the year of the cancellation, taxed at your ordinary rate rather than the lower capital gains rate.²³

Your lender reports the forgiveness to you and to the IRS on Form 1099-C. Leaving it off your return doesn’t hide it. The IRS matches the form and sends a notice adjusting your return, adding interest to the balance.⁴

What Changed on January 1, 2026

Internal Revenue Code Section 108(a)(1)(E) let homeowners exclude forgiven mortgage debt on a primary residence, capped at $750,000 for joint filers and $375,000 for married filing separately. The loan had to be “acquisition indebtedness,” meaning it was used to buy, build, or substantially improve the home you actually lived in. Debt on vacation homes, rental properties, or cash-out proceeds spent on unrelated things like credit card payoffs never qualified.¹

That exclusion expired on January 1, 2026. A bill to make it permanent (H.R. 917) has been introduced, but as of early 2026 it has not been enacted. If your mortgage debt is forgiven in 2026 or later without a pre-existing written agreement, the full forgiven amount is taxable unless you qualify for one of the exclusions below.

The Pre-2026 Written-Agreement Carve-Out

One important exception survives. If you entered into a written arrangement for the forgiveness before January 1, 2026, the exclusion still applies even if the actual discharge happens later. The statute covers debt “subject to an arrangement that is entered into and evidenced in writing before January 1, 2026.”¹ If you were negotiating a short sale or loan modification in late 2025 and got the terms into writing before the deadline, keep that agreement. It’s the single most important document proving your eligibility when you file Form 982.

Exclusions That Still Work

Two broader Section 108 exclusions apply to all canceled debt, not just mortgages, and neither has an expiration date.

Insolvency

You are insolvent if the total of everything you owe exceeds the fair market value of everything you own, measured immediately before the debt is canceled. This is the exclusion most homeowners in distress will want to test, because people going through foreclosure or short sale are usually underwater on more than the mortgage.⁵

The exclusion is capped at the amount by which you were insolvent. If your liabilities exceeded assets by $80,000 and the lender forgave $120,000, you exclude $80,000 and pay tax on the remaining $40,000.²

Publication 4681 includes an insolvency worksheet. Count assets broadly: retirement accounts, cash value in life insurance, vehicles, household goods, pension interests. Count liabilities broadly too: the mortgage itself, credit cards, car loans, student loans, medical bills, unpaid taxes. Most people undercount their liabilities and shortchange themselves.

To claim it, file Form 982 with your return, check line 1b, and put the excludable amount on line 2.⁶

Bankruptcy

Debt discharged in a Title 11 bankruptcy, Chapter 7 or Chapter 13, is excluded from income with no dollar limit. Claim it on Form 982 by checking line 1a.¹ You can’t stack this with the insolvency exclusion on the same debt. If the cancellation happened in bankruptcy, the bankruptcy rule controls; the insolvency calculation only matters for debts canceled outside bankruptcy.

How Foreclosures, Short Sales, and Modifications Trigger Tax

In a foreclosure, the lender takes the home and applies its value against your loan balance. Any leftover balance the lender writes off becomes cancellation of debt income. A short sale works the same way: the gap between the sale price and the outstanding balance is the forgiven amount. Either produces a 1099-C.⁴

Loan modifications trigger the tax only when the lender reduces the principal balance. Cutting your balance from $300,000 to $240,000 generates $60,000 of cancellation income. Modifications that only lower the interest rate or stretch the term don’t.

Recourse vs. Non-Recourse Debt

Whether the lender can pursue you personally, or only the property, changes everything about how the tax splits. About a dozen states treat purchase-money home mortgages as non-recourse by default.

With non-recourse debt, a foreclosure is treated as a sale. Your amount realized equals the full outstanding loan balance, even if the property was worth less, and the taxable amount is the difference between that balance and your adjusted basis, taxed as capital gain or loss. There is no separate cancellation of debt income because the lender never had a right to come after you.⁷

With recourse debt, the IRS splits the transaction. First, gain or loss on the property is calculated using fair market value as the sale price. Second, the amount by which the canceled debt exceeds fair market value is cancellation of debt income at ordinary rates.⁸ A recourse foreclosure can hit you with both a capital gain and ordinary income in the same year.

The Section 121 Exclusion Can Absorb the Capital Gain Side

Losing a home to foreclosure can create a capital gain. Say you bought for $200,000, the market pushed value to $350,000, and you owed $400,000 when you defaulted: the recourse foreclosure produces a $150,000 gain on the property plus $50,000 of cancellation income. If you owned and used the home as your primary residence for at least two of the five years before the foreclosure, Section 121 lets you exclude up to $250,000 of that gain ($500,000 for joint filers). The statute treats foreclosures and involuntary conversions as sales for this purpose.⁹ Section 121 does not touch the cancellation of debt piece, which still needs one of the Section 108 exclusions.

The Two Forms That Do the Work

Form 1099-C

Lenders must send Form 1099-C by January 31 of the year after the cancellation. Box 2 is the forgiven amount, the number the IRS expects to see reflected as income on your return. Box 7 is the fair market value of the property if a foreclosure or abandonment occurred with the cancellation.¹⁰

Look at Box 7 carefully. The lender’s valuation determines how the taxable amount splits between cancellation of debt income and capital gain or loss, so a wrong figure shifts your tax. The form itself tells you to contact the creditor if you disagree.

Form 982

Form 982 is how you tell the IRS the canceled debt should not be taxed. Without it, the IRS treats the full 1099-C amount as income. Check the box for your exclusion: 1a for bankruptcy, 1b for insolvency, or 1e for qualified principal residence indebtedness under the transition rule. Enter the excluded amount on line 2.⁶

There’s a catch when you still own the home. Claiming the qualified principal residence exclusion or the insolvency exclusion while keeping the property requires you to reduce your home’s tax basis by the excluded amount, reported on line 10b.² A lower basis means a larger taxable gain the day you eventually sell. The exclusion doesn’t erase the tax so much as push part of it to a later year.

Attach Form 982 to your Form 1040 when you file, and make sure its figures match the 1099-C. Mismatches are one of the most common triggers for automated IRS notices.⁶

Records to Keep

The normal period of limitations on an income tax return is three years, but it stretches to six years if you leave more than 25% of gross income off the return.¹¹ For a large canceled debt, hold everything for at least six years: the 1099-C, your Form 982, the written agreement with your lender, closing statements, and any correspondence.

If you excluded canceled debt and reduced your home’s basis, keep the purchase records, improvement receipts, and the basis reduction figure for as long as you own the property and for three years after you file the return that reports the eventual sale. Without those records, you can’t prove your adjusted basis when the IRS asks.¹²

1
Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness
2
Internal Revenue Service. Publication 4681 – Canceled Debts, Foreclosures, Repossessions, and Abandonments
3
Congressional Research Service. The Tax Treatment of Canceled Mortgage Debt
4
Internal Revenue Service. Topic No. 431, Canceled Debt – Is It Taxable or Not
5
Internal Revenue Service. What if I Am Insolvent
6
Internal Revenue Service. Instructions for Form 982 – Reduction of Tax Attributes Due to Discharge of Indebtedness
7
Internal Revenue Service. Recourse vs Nonrecourse Debt
8
Internal Revenue Service. Publication 544 – Sales and Other Dispositions of Assets
9
Office of the Law Revision Counsel. 26 USC 121 – Exclusion of Gain From Sale of Principal Residence
10
Internal Revenue Service. Form 1099-C – Cancellation of Debt
11
Internal Revenue Service. Topic No. 305, Recordkeeping
12
Internal Revenue Service. How Long Should I Keep Records