Forgiven Mortgage Debt Is Taxable Again in 2026: Short Sale Math

For almost two decades, a homeowner who lost a house in a short sale or foreclosure could at least avoid a tax bill on the part of the mortgage the bank wrote off. Congress created the exclusion in 2007 for the subprime crisis and extended it again and again. The last extension, in the Consolidated Appropriations Act, 2021, moved the end date to January 1, 2026 and cut the limit from $2 million to $750,000. That date has now passed. The draft Publication 4681 for 2026 lists it as the first item under What’s New: qualified principal residence indebtedness “cannot be excluded from income for discharges completed or discharge arrangements entered into after 2025.”

What the law says now

Section 108(a)(1)(E) of the Internal Revenue Code still exists, but it applies only to qualified principal residence indebtedness discharged:

1. “before January 1, 2026,” or
2. “subject to an arrangement that is entered into and evidenced in writing before January 1, 2026.”

The budget law signed on July 4, 2025, Public Law 119-21, rewrote the student loan exclusion in the same section but did not touch this date. A bill to make the exclusion permanent, H.R. 917, the Mortgage Debt Tax Forgiveness Act of 2025, was introduced on February 4, 2025, and referred to the Ways and Means Committee; as of November 3, 2026, govinfo shows only that introduced version.

Under the general rule, canceled debt is income. Without the exclusion, it goes on Schedule 1 (Form 1040), line 8c, and is taxed at ordinary rates.

Who is still covered by the old rule

The transition rule matters for anyone whose workout started in 2025 and finished in 2026. If the discharge is “subject to an arrangement that is entered into and evidenced in writing before January 1, 2026,” the exclusion applies with its old conditions:

• The debt must be qualified. A mortgage taken out to buy, build or substantially improve your main home and secured by it. A refinance counts only up to the principal balance of the old mortgage just before the refinance; cash taken out for credit cards, tuition or a car does not.
• The cap is $750,000, or $375,000 if married filing separately.
• The reason must be value or hardship. The exclusion does not apply if the cancellation was for services you performed for the lender or for any other reason not directly related to a decline in the home’s value or your financial condition.
• The ordering rule. If part of the loan is not qualified, the canceled amount is first treated as coming from the nonqualified part. In the Publication 4681 example, a borrower who took $110,000 of cash out in a refinance and later had $115,000 canceled in a short sale can exclude only $5,000 under this rule. The remaining $110,000 needs another exclusion or is taxable.

You claim it on Form 982, line 1e, and reduce the basis of the home by the excluded amount if you keep it. The IRS does not define what qualifies as an “arrangement”; a signed modification or short sale agreement dated in 2025 is the clearest case. A phone call or an application that was still pending on December 31, 2025, is much weaker evidence, and it is the kind of question to settle with a tax professional before filing.

A 2026 short sale, with and without insolvency

Take a single homeowner who bought a house in 2022 for $350,000. In 2026 the mortgage balance is $320,000, the house is worth $280,000, and after a job loss the lender approves a short sale at $280,000 and forgives the remaining $40,000. The loan is recourse, meaning the borrower was personally liable. Selling costs are ignored to keep the numbers clean. There are two separate tax results.

The sale. The amount realized is $280,000 against a basis of $350,000: a $70,000 loss. A loss on a personal residence is not deductible, so it does nothing.

The canceled debt. The $40,000 is ordinary income. Suppose the homeowner also earned $60,000 in wages and takes the 2026 standard deduction of $16,100. Taxable income rises from $43,900 to $83,900. The first $6,500 of the canceled debt fills the rest of the 12 percent bracket, which ends at $50,400, and the other $33,500 falls in the 22 percent bracket:

Before 2026, that $8,150 would have been $0 under the qualified principal residence indebtedness exclusion.

The insolvency exclusion still works. You do not include canceled debt in income “to the extent that you were insolvent immediately before the cancellation,” meaning your liabilities exceeded the fair market value of everything you owned. Publication 4681 is explicit that assets include collateral and exempt assets such as a pension or retirement account. Suppose, immediately before the short sale closed, this homeowner had:

The homeowner was insolvent by $20,000, so $20,000 of the $40,000 is excluded on Form 982, line 1b, and $20,000 is taxable. Taxable income becomes $63,900 and the tax on the canceled debt falls to $3,750 ($780 at 12 percent plus $2,970 on $13,500 at 22 percent). An exclusion also means reducing tax attributes in Part II of Form 982, which for most households means basis in other property.

Note how much the retirement account matters: a household with a larger 401(k) can be solvent on paper even after losing a house. Publication 4681 includes an insolvency worksheet for the calculation.

Foreclosure: recourse or nonrecourse decides everything

A foreclosure is treated as a sale, and Publication 4681’s Table 1-1 splits it in two depending on whether you were personally liable.

• Recourse debt. Ordinary income from canceled debt is the outstanding debt (minus anything you remain liable for) less the fair market value of the house. Gain or loss is the smaller of the debt or the fair market value, plus any proceeds you received, minus your basis. In the example above, a recourse foreclosure instead of a short sale gives the same $40,000 of canceled debt income, if the lender does not pursue the rest, and the same nondeductible loss.
• Nonrecourse debt. If you were not personally liable, there is no canceled debt income at all. The foreclosure is a sale for the full $320,000 of debt. Against a $350,000 basis that is a $30,000 nondeductible loss. If your basis were $250,000, it would be a $70,000 gain, which the home sale exclusion of section 121 can shelter, up to $250,000 or $500,000 on a joint return, if you owned and lived in the home for two of the last five years.

Whether a mortgage is recourse or nonrecourse depends on the loan documents and on state law; some states limit or bar deficiency judgments on certain home loans. Box 5 of Form 1099-C shows whether the lender reports that you were personally liable for repayment. If you simply move out, Publication 4681 explains that for recourse debt, abandonment alone does not trigger gain or loss until the foreclosure is completed, which can move the tax into a later year.

Other exclusions that still apply

• Bankruptcy. Debt canceled in a title 11 bankruptcy case is excluded entirely, on Form 982, line 1a. It takes precedence over every other exclusion.
• Insolvency, as above, which is available for any canceled debt, not only mortgages.
• The written-arrangement transition for qualified principal residence indebtedness, as above.

None of these is automatic. The lender’s Form 1099-C reports the canceled amount to the IRS, and you claim the exclusion by attaching Form 982 to your return. For 2026 events, Publication 4681 says Forms 1099-A and 1099-C should be sent to you by February 1, 2027. How to read the 1099-C and fill in Form 982 for insolvency is covered in Form 1099-C and the Form 982 insolvency exclusion.

What to do before agreeing to a workout in 2026

• Ask whether the lender will waive the deficiency or only stop collecting. Only the canceled amount is income; a deficiency you still owe is not.
• Run the insolvency numbers first, using values from the day before the expected cancellation, and keep the statements.
• Check whether the loan is nonrecourse. A foreclosure on nonrecourse debt has no canceled debt income at all.
• Plan for the tax. If the canceled amount will be taxable, raise your withholding or make an estimated payment in the quarter the sale closes to avoid an underpayment penalty, or plan for a payment plan if needed.

The same expiration happened to income-driven student loan forgiveness, which became taxable again on January 1, 2026; see the student loan tax bomb.

Sources

• Internal Revenue Service — Draft Publication 4681 (2026), Canceled Debts, Foreclosures, Repossessions, and Abandonments, dated August 5, 2026: What’s New, Insolvency, Qualified Principal Residence Indebtedness (Examples 1 to 3, exclusion limit, ordering rule), Table 1-1, Abandonments
• Legal Information Institute, Cornell Law School — 26 U.S.C. 108, subsections (a)(1)(E), (a)(2) and (h), and the amendment notes for Public Law 116-260, section 114; 26 U.S.C. 121
• U.S. Government Publishing Office — H.R. 917, Mortgage Debt Tax Forgiveness Act of 2025, introduced in House, February 4, 2025