There are several things to keep in mind when it comes to dealing with the tax consequences of foreclosure. Things like the fair market value of a home, the amount of debt forgiven and recent government legislation can all factor into the taxes on your foreclosure. Depending on your circumstances, you may be hit with a double whammy. Not only will you have to deal with foreclosure, but you may have to pay taxes on the difference if your lender accepts an amount short of the full loan (like in short sales).

Cancellation of debt taxation

Lenders can choose to forgive part or all of a debt you owe. The amount of debt canceled (cancellation of debt, or COD) is then counted as income for you. In general, COD income is taxable and the lender is required to report the amount to you as the borrower, and also the IRS. However, there are some exceptions in which COD income is not taxable:

  • Bankruptcy: If the COD occurs while you’re in Title 11 bankruptcy proceedings, the COD income is exempt from federal taxation.
  • Insolvency: If you owe more in debts than you own in assets (insolvency), any COD income is exempt from taxation, up to the amount that makes your debts and assets equal. If the debt cancellation makes you solvent (when your assets are enough for you to pay all your debts), the COD income is taxable to the extent in which it makes you solvent. The remaining COD income will be exempt.
  • Home mortgage: Up through 2012, you can have up to $2 million in canceled debt for your principal home, tax-free. Debt used to acquire, build, or improve a main residence and is secured by that residence qualifies. Refinanced debt can also qualify under certain stipulations. The tax basis of a homeowner's income(usually the purchase price) must be reduced by the amount of COD income.
  • Deductible interest: If your canceled debt income includes interest that could have been deducted (if you’d made the payments), then the interest is also tax-free. This applies with forgiven principal residence mortgage interest, vacation mortgage interest and rental property mortgage interest.
  • Seller-financed debt: If COD income comes from seller-financed debt -- mortgage debt owed to the previous property owner -- it's exempt from federal income taxation. There is a catch. Your basis in the property must be reduced by the amount you're allowed to treat as tax free.

When foreclosure is a loss (FMV < original purchase price)

Paying off your mortgage debt with the sale of your house leaves an unpaid balance (deficiency) if the fair market value is less than your original purchase price. When there is this imbalance, the foreclosure can cause a tax loss that is considered a non-deductible personal expense for federal income tax purposes. If the deficiency is forgiven, it can become taxable COD income.

When foreclosure is a gain (FMV > original purchase price)

Occasionally the fair market value of your property is greater than the debt the bank is trying to recoup, in which case the foreclosure triggers a gain that is taxable. However, you can probably exclude the gain thanks to the federal home sale gain exclusion break. On the state level, the taxation law varies in this situation. Homeowners can end up with taxable COD income in this situation, as well.

Home mortgage exception through 2012

The Mortgage Forgiveness Debt Relief At of 2007 can allow you to exclude income from the discharge of debt on your principal residence, as in the cases of a restructured mortgage or if mortgage debt is forgiven. This provision applies to debt forgiven from 2007-2012. Up to $2 million of forgiven debt is eligible. As always, consulting an attorney experienced with foreclosure dealings will help prepare you for the best or the worst consequences of your foreclosure.