Mortgage cancellation typically means that a lender has cancelled, or forgiven, the debt owed by the borrower. This should not be confused with a discharged debt, which is conducted by a bankruptcy court, not the creditor that holds the claim to payment. Lenders rarely cancel an entire mortgage. It is more common for a lender to cancel part of the remaining mortgage debt as part of a debt consolidation or restructuring process.
One common type of mortgage debt cancellation occurs during a short sale, a compromise between the debtor and lender to avoid foreclosure. In a short sale, the homeowner sells the house and uses the funds to pay off the mortgage and end the contract with the lender. When house prices have fallen, the proceeds from the sale may not be enough to pay off the entire mortgage, so lenders often agree to forgive or cancel the remaining debt to end its association with the account.
Debt cancellation means the lender has taken a loss, which can be recorded on lender taxes and lead to lower taxes. However, lower taxes for the lender mean higher taxes for the debtor. The IRS considers the cancelled mortgage debt as income received by the debtor, and the IRS charges income taxes on the cancelled debt during the year the mortgage was cancelled. Debtors must consider this added cost when making financing decisions.
There is another way to cancel a mortgage, known as a rescission. This does not remove the debt, but it cancels the foreclosure. The debtor owes the entire principal to the lender, but the mortgage fees are subtracted from the owed amount, and the loan process itself is ended. There are several requirements for a rescission. The debtor must have refinanced, and the rescission must occur no more than three years after the loan has been created.