Many California residents may have heard of the multi-state settlement that was reached recently with many of the nation’s largest lenders. The settlement includes a provision under which lenders will reduce a portion of the principal on some mortgages. However, before accepting a mortgage modification, homeowners should be aware of some IRS regulations.

When a person goes to pay taxes, it is important to keep in mind that it is not just a salary that can count as income. In fact, a lot of things may count as income, including even a mortgage modification. This is because when a lender forgives all or part of a loan that totals to $600 or more, that amount must be reported as income to the IRS.

For example, say a homeowner has a mortgage with a principal balance of $150,000. If the homeowner’s lender reduces that mortgage to $145,000, then the $5,000 difference needs to be reported as income on Form 1099-C. Thus, many California residents may find themselves saddled with a significant tax bill for a loan forgiveness of just $5,000.

Fortunately, some exclusions do apply, and a homeowner may not always have to pay taxes on the amount of the mortgage modification. Yet if the homeowner does not qualify for an exclusion, then he or she may be simply trading one debt for another, albeit at a greatly reduced amount. So before accepting a mortgage modification, Californians may first wish to review the tax implications lest they find themselves having to pay unexpected taxes to the IRS.

Source: ABC News, “Mortgage Modifications: When to Say Yes or No,” Gerri Detweiler, March 11, 2012