Foreclosure & Income Taxes
Not very many homeowners would consider the foreclosure of their homes to be a source of income. However, the IRS can tax your debt cancellation as if it were income provided to you by your lender. There are methods of avoiding this process, but you must meet certain qualifications first.
Where Did Your Debt Go?
When your home goes into foreclosure, your lender has several options. Your debt may be forgiven, part of the debt may be forgiven, or none of the debt may be forgiven. Both you and the lender must report the status of the debt to the IRS. When your debt is cancelled, or forgiven, the lender files form 1099-C, Cancellation of Debt. How you claim the debt is contingent upon whether the debt will be taxed or excluded.
The IRS Wants In
The IRS has a right to tax the forgiveness of your debt as income. The lender "pays" the balance of your loan through a tax write off. When you received the mortgage, it was not considered income because you were legally obligated to repay. However, when the lender claims the cancelled debt, you become responsible. However, if you meet certain exclusions, you can avoid Cancellation of Debt taxation altogether.
Responding to COD Request
If you are insolvent or bankrupt, you may be able to claim an exclusion on your tax return for Cancellation of Debt taxation. Insolvency occurs when your liabilities are greater than the Fair Market Value of your assets. Many homeowners run into foreclosure due to financial hardship, but this hardship is not always related to a shortage of assets. When you receive a notice from the IRS explaining your Cancellation of Debt penalty, contact a tax professional. Insolvency calculations can be complex. Your tax preparer can determine the extent to your insolvency using IRS Form 982.
Is the Financial Storm Over?
Bankruptcy is a simple way out of the Cancellation of Debt taxation. Even if the IRS determines you are insolvent, it does not mean the tax burden is completely alleviated. You could still be partially responsible for taxes on the remaining mortgage balance. In addition, if your mortgage debt is not completely forgiven, you could also be subject to a judgment whereby the lender seeks to recoup the remaining balance on your loan. Not all states allow mortgage judgments following foreclosure. Consult with a tax attorney to learn your foreclosure rights.
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