The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.
This provision applies to debt forgiven in calendar years 2007 through 2014 and it was extended till the end on 2015.
It is set to expire in 2016 unless it will be extended again.
Regarding state taxes - some states do not conform with the federal law.
Specifically Michigan allows exclusion from AGI when COD (cancellation of debt) income is discharged for the mortgage on a principal residence.
-- When a COD is excluded from AGI, it is not added back on the MI-1040
-- When a COD is excluded from AGI, it must be included in household income
Adjusted Gross Income (AGI) – This is the amount from your U.S. 1040 line 37
Household Income (HHI) – Household income includes all income received by all adult household members during the year, including income that might be exempt from federal adjusted gross income.
There is an exception - a COD on a mortgage can be excluded from household income when the lender does not foreclose, but agrees to reduce the amount owed. Ownership of the home does not change. This is sometimes known as a ‘workout’. The owner would likely receive a 1099-C but not a 1099-A.
In a ‘workout’ the COD is not part of household income because any gain or loss on the sale of the house is postponed until the owner sells. The basis – a value used to compute gain or loss on a sale – is adjusted by the COD. As a result, when the owner eventually sells the house he/she may recognize more gain (assuming they sell it for a gain) which will be included in the household income at that time.