Canceled debt on your principal residence. If you had debt canceled on your principal residence in 2007, you may be able to exclude part or all of the amount canceled from your income. However, if you continue to own your residence after the cancellation, you must reduce the basis of your principal residence (but not below zero) by the amount excluded from income. For more information, see Qualified Principal Residence Indebtedness, later.

Expiration of exclusion of debt canceled because of Hurricane Katrina. The exclusion for canceled nonbusiness debt by certain persons whose principal residence on August 25, 2005, was located in the Hurricane Katrina disaster area is not available after 2006. If you were eligible to exclude such income in 2005 or 2006, you must use the January 2006 revision of Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

Photographs of missing children. The Internal Revenue Service is a proud partner with the National Center for Missing and Exploited Children. Photographs of missing children selected by the Center may appear in this publication on pages that otherwise would be blank. You can help bring these children home by looking at the photographs and calling 1-800-THE-LOST (1-800-843-5678) if you recognize a child.

This publication explains the federal tax treatment of canceled debts, foreclosures, repossessions, and abandonments.

Generally, if you owe a debt to someone else and they cancel or forgive that debt, you are treated for income tax purposes as having income and may have to pay tax on this income. This publication refers to this as “canceled debt” whether it is canceled or forgiven. However, under certain circumstances, you may not have to include canceled debt in income. If you do exclude canceled debt from income, you may also be required to reduce “tax attributes.” Reduction of tax attributes is discussed in more detail later in this publication.

If you have property that is security for a debt and that property is taken by the lender in full or partial satisfaction of your debt, you will be treated as having sold that property and may have gain or loss as a result. For this purpose, it does not matter whether the lender took the property through foreclosure, repossession, a voluntary conveyance by you to the lender, or your abandonment of the property. If the lender cancels debt in excess of the fair market value (FMV) of the property taken by the lender, the excess of the canceled debt over the FMV of the property may have to be treated by you as ordinary income from the cancellation of debt in addition to any taxable gain that you may have had from being treated as having sold the property.

If you are treated as having sold the property, any gain you have will generally have to be reported on your income tax return. If you have a loss, you may be entitled to deduct the loss if the property that was returned to the lender is business or investment property, but not if it is personal use property, such as your residence.

This publication discusses the general rule requiring canceled debt to be included in income, exceptions to the general rule, exclusions from the general rule, and the ordering rules for reduction of tax attributes by reason of the exclusion of canceled debt from income. This publication also discusses the tax treatment resulting from foreclosures, repossessions, and abandonments and provides detailed examples with filled-in forms.

The sections of this publication that will apply to you depend on the type of debt canceled, the tax attributes you have, and whether or not you continue to own the property that was subject to the debt. Some examples illustrating common circumstances are provided below to help guide you through this publication. These examples do not cover every canceled debt situation, but are intended to provide general guidance for the most common situations.