Tax Consequences of a Foreclosure

If all your efforts fail and your home is foreclosed, you may wonder whether there is an IRS tax bill lurking in the aftermath waiting to add more misery to a series of unfortunate events. The answer is somewhere between yes and no depending on whether the foreclosed home was your primary residence or not.

Foreclosure on a Primary Residence

The Mortgage Forgiveness Debt Relief Act of 2007 provides a tax break on discharged mortgage debt related to a foreclosure on a primary residence. Additionally, debt forgiven through mortgage restructuring, or in other words a loan modification, also qualifies for this relief. But there are some restrictions:

1. There is a $2 million limit, or $1 million for a married person filing a separate return, on the forgiven debt.
2. The tax break only applies to mortgage debt discharged by a lender in 2007, 2008 or 2009.
3. The loan must have been used to buy or build a primary residence.

Foreclosure on a Vacation, Rental or Second Home

A homeowner is still responsible for taxes as usual if the debt forgiven is on a non-primary residence. This means that the forgiven debt is treated as regular income on a cancellation of debt.

Cancellation of Debt as Income Explained

When you borrow money and the lender later cancels or forgives the debt you will likely have to report the cancelled debt amount as income to the IRS for tax purposes. The reason why the debt once cancelled is then considered income is that the money received through what was originally a loan is no longer scheduled to be repaid, though the “borrower” is still that much “richer” from the money received, which in other words is income gained. The lender is usually required to report the amount of the cancelled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.

There are some exceptions to taxable cancellation of debt income in addition to income exempted under the Mortgage Forgiveness Debt Relief Act of 2007.

1. Bankruptcy - Debts discharged through bankruptcy are not considered taxable income.
2. Insolvency - Defined as when your total debts are more than the fair market value of your total assets, which can be complex to determine and requires the assistance of a tax professional.
3. Non-Recourse Loans – In this case, a lender cannot pursue you personally in case of default and their only remedy is to repossess the property financed or used as collateral. Certain Farm Debts - The rules for this exception applicable to farmers are complex and require the assistance of a tax professional.