Foreclosure Tax Consequences

Forgiven debt is treated as income by the IRS.

Forgiven debt is treated as income by the IRS.

Besides the loss of your home, a significantly reduced credit rating and perhaps even a slimmer bank account, a foreclosure will also affect your tax base. As a result, you may find that you are now required to pay a larger tax obligation. However, recent policy changes and existing IRS provisions may offer some relief.

The 1099 Form

Once a foreclosure is complete, the lender will issue you a 1099 form, unless you are still responsible for any deficiencies owed to the bank. For example, if you owed the bank $100,000 and the bank was able to recoup $80,000 from the foreclosure sale, then you will receive a 1099 form for $20,000, which is the difference owed.

Canceled Debt Is Taxable Income

Since a foreclosure is deemed to be a &ldquo;cancelation of debt&rdquo; by the IRS, it is treated as taxable income. This is because you previously had an obligation to repay the debt, and therefore incurred a liability. Once the debt has been forgiven, you are no longer required to repay the monies owed and as such have earned additional income. According to the example above, you will now have to report the $20,000 of forgiven debt as additional income on your tax return.

Gains From Property Disposition May Be Taxable

In some cases, you may have profited from the foreclosure, at which point the gain would be taxable as income. This is calculated by deducting your basis in the property--the purchase price plus the cost of any major improvements--from the fair market value of the property foreclosed. If the amount is positive, you have profited. However, if you used the property as your principal residence for at least two years, you may exclude up to $250,000 from income; $500,000 for married couples filing jointly.

The Mortgage Forgiveness Debt Relief Act

In 2007, the Mortgage Forgiveness Debt Relief Act allowed taxpayers to exclude income from canceled debt on their principal residence. Taxpayers are also allowed to exclude debt reduced through mortgage restructuring and mortgage debt forgiven due to foreclosure. However, this provision only applies to debt forgiven from 2007 through 2012, and is capped at $2 million; $1 million if married and filing separately.

Tax Exceptions for Canceled Debt

After a foreclosure, most likely you will not be in the best financial situation to pay off excessive tax obligations. The IRS has certain provisions that will allow you to avoid large penalties due to a foreclosure. For example, the IRS allows you to exclude from income any debt discharged through bankruptcy. The same consequence can be obtained by declaring insolvency. In order to claim insolvency, you must prove that your liabilities exceed the fair market value of your total assets. Non-recourse loans are also excluded from income. With a non-recourse loan, the lender can only claim the collateral in the event of default and is barred from pursuing you, the borrower, personally.

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