Tax Break for Paying Off a Second Mortgage at a Discount

Benefits

Lenders will sometimes forgive some of the principal amount on secondary mortgages when a homeowner gets behind on his mortgage payments, because the lender on the homeowner’s first mortgage has the right to collect equity in the property first after a foreclosure sale, often leaving the second lender with a complete loss of the loan’s value. If the U.S. government allows the homeowner to exclude the discount from his income, she can save a substantial amount of money on the loan principal and interest by paying off her loan at a discounted price.

Homeowners can only qualify for a tax break if they have a second mortgage secured on their primary residence and they used the proceeds from their HELOC or home equity loan to make improvements to their property, according to the Internal Revenue Service. Those who spent the proceeds from their second mortgage on anything other than improvements do not qualify for tax relief. The U.S. government does not permit tax breaks for discounted mortgage payoffs on investment properties and second homes.

The IRS will consider the lender’s discount as a taxable event for the homeowner under any other circumstances. In this case, the lender will send the homeowner a 1099-C form by mail, which the homeowner will have to report as income on his Form 1040 tax return. This form shows the difference between principal owed and the discount payoff. The U.S. government can levy an income tax rate of up to 35 percent on the discounted amount as of 2011, according to Oblivious Investor.

The discount that a homeowner receives on a second mortgage cannot exceed $2 million if married and filing jointly or single, or $1 million if married and filing separately, according to the State of California Franchise Tax Board. As of 2011, homeowners can only claim a tax break on debt forgiven from 2007 to 2012. Since the IRS assumes that canceled debt is taxable unless notified otherwise, U.S. taxpayers must claim their tax break by completing IRS Form 982, taking care to check box 1(e) and entering their total discount on line 2.