What Is an Underwater Mortgage?

An underwater mortgage means you owe more on your home loan than your property is actually worth. For example, let’s say your house is valued at $200,000, but your mortgage balance is $250,000. That $50,000 gap puts you “underwater.” This can happen if home prices fall in your area, or if you bought with a low down payment and prices didn’t rise as expected. Sometimes, unexpected repairs or local economic downturns can also sink home values.

Being underwater creates big headaches if you need to sell or refinance. If you sell, you won’t get enough from the sale to pay off the loan. And most lenders won’t refinance a loan bigger than the home’s value. That’s why people with underwater mortgages often feel stuck until prices go up or they find another solution.

What Happens When Your Property Faces Condemnation?

Condemnation might sound like your house is falling apart, but legally it’s something different. It’s when the government or another authorized group takes your property for a public purpose, like building a new road, expanding a school, or creating a park. This process is called eminent domain.

You’ll usually get paid for your property, but the catch is the compensation might not cover everything you owe on your mortgage, especially if you’re underwater. If your house is condemned and the payout doesn’t pay off your entire loan, you’re left with a shortfall. That’s when things get complicated, because someone still has to deal with the remaining debt.

Here’s a simple example: Imagine you owe $300,000 on your home, but the city offers $220,000 as fair market value during condemnation. The sale goes through, your lender gets the $220,000, but there’s still $80,000 left unpaid. Now, you and your lender have to figure out what happens with that leftover debt.

How Underwater Mortgage Condemnation Can Lead to COD Income

This is where “COD income” comes in. COD stands for “cancellation of debt.” If the lender decides to forgive any part of your unpaid mortgage after condemnation, let’s say they wipe out that $80,000 difference, the IRS may treat the forgiven amount as taxable income. It feels strange, but the tax code treats forgiven debt almost like getting extra money.

For example, suppose after the condemnation, your lender forgives the entire $80,000 shortfall. Even though you never actually received that money, the IRS could consider it income, and you might owe taxes on it. You could get a 1099-C form in the mail reporting the canceled debt. If you aren’t ready for this, tax season might come with a nasty surprise.

It’s important to note that this isn’t just a hypothetical problem. Many people discover, after their property is condemned and their lender forgives the rest of the loan, that they suddenly have a tax bill for thousands of dollars. This is what’s known as COD income risk.

What Is Short Payoff Taking and Debt Forgiveness?

Short payoff taking refers to your lender agreeing to accept less than the full amount you owe to settle your debt. In the context of condemnation, this often happens when the government’s payment doesn’t cover your mortgage. Let’s say your lender receives the partial payment from the government, then chooses to forgive the remaining balance. That forgiven balance is called a debt forgiveness award.

While debt forgiveness sounds helpful, it can create tax headaches. The IRS generally views forgiven debt as taxable income unless you qualify for an exception. The lender will likely send you a 1099-C form, which you’ll need to include when you file your taxes. If you don’t plan for this, you could owe more taxes than you expect.

Let’s say your lender forgives a $50,000 shortfall. You may need to pay income taxes on that $50,000, even though you never physically received it. That’s why it’s important to understand how short payoff taking and debt forgiveness work, and to know what paperwork to expect.

How to Minimize COD Income Risk After Condemnation

If you’re facing underwater mortgage condemnation, there are practical steps you can take to limit your tax risk:

  1. Find out if you qualify for an exclusion or exception. For example, you might avoid COD income tax if you’re insolvent (your total debts are greater than your total assets) or if your property qualifies as business or investment property. The IRS has specific rules about these situations.
  2. Talk to your lender before agreeing to any settlement. Ask how they’ll report the debt forgiveness and whether any portion might not be considered taxable. Some lenders might be willing to work with you to limit your COD income exposure, especially if you’re proactive about it.
  3. Work with a tax professional. Tax laws around COD income are tricky, and mistakes can cost you thousands. A qualified tax advisor can review your situation, help you calculate potential tax, and suggest ways to minimize what you owe.