This post is a brief review of IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonment (For Individuals) as it relates to mortgage debt forgiveness.

If your debt is reduced or eliminated you normally will receive a year-end statement, IRS Form 1099-C, Cancellation of Debt from your lender. By law, this form must show the amount of debt forgiven and the fair market value of any property foreclosed. Scrutinize the Form 1099-C carefully. Notify the lender immediately if any of the information shown is incorrect. You should pay particular attention to the amount of debt forgiven in Box 2 as well as the value listed for your home in Box 7.

Canceled debt is normally taxable. However for tax years 2007 through 2012 (unless extended) homeowners may exclude up to $2 million of debt forgiven on their principal residence for income for income tax reporting purposes. The limit is $1 million for a married person filing a separate return. Also you may exclude debt reduced through mortgage restructuring, as well as mortgage debt forgiven in a foreclosure.

To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence. Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion. Proceeds of refinanced debt used for other purposes such as paying off credit card debt – do not qualify for the exclusion. Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the tax relief provision. In some cases, however, other tax relief provisions – such as insolvency – may be applicable. IRS Form 982, Reduction of Tax Attributes Due to Discharge of indebtedness provides more details about these provisions.

If you qualify, claim the special exclusion by filling out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attach it to your federal income tax return for the tax year in which the qualified debt was forgiven. In some cases other tax relief provisions such as insolvency may be applicable and worth consideration.