While I will defer to other attorneys who answer this question who are better versed in the tax code than I am, I don't think what you state in your question is entirely correct.
Once a foreclosure occurs, and the sale proceeds, the remaining amount owed becomes a judgment against you and in favor of the bank. The bank can attempt to collect this judgment against you, but, it appears, would not have much success. But there is no "income" to tax, as you still owe the full amount of the judgment.
The story changes if the bank "forgives" the deficiency, which can happen post-judgment or can happen if you settle the case with a short sale or stipulated foreclosure with "waiver of deficiency." In that circumstance, the IRS will treat it as though you have received "income" in the amount of the deficiency that has been waived, since you no longer owe the deficiency amount.
In either event, you may be able to fight the tax liability through the insolvency tax exclusion, bankruptcy, and/or the use of IRS Form 982. When that event occurs, I recommend talking to a tax adviser about these options.
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Here is how this works. If the house sells for $45,000 and you owe $115,00, that means there is a $70,000 deficiency. The bank has two choices. They can either pursue you for a "deficiency judgment" or they can write-off the sum as a bad debt and take it as a deduction on their books. Chances are they'll choose the latter in almost every foreclosure case, and my experience is that is what they usually do. To make sure their accounting works out, they'll file a 1099-C with the IRS. The IRS, in turn, will treat this as Cancellation of Indebtedness Income under IRC Section 108. That will mean you would owe tax on the amounts owed at your normal rate. Probably, this would mean about $14,000 of tax you would owe.
The IRS will probably not levy your SSDI, but may go after your retirement income. However, with a debt at this level, you are entitled to a payment plan under the IRS Fresh Start Program. The payment plan would be a 72 month payment plan that you can enter over the phone without providing any income verification. Assuming the figure of $14,000, you are talking about a total monthly payment of $194/mo. So, this may not be the end of the world.
Now, if you have a foreclosure defense, which could potentially drag foreclosure efforts out for years, or agree to drop your defenses and provide a deed in lieu of foreclosure or agree to a short sale, you may be able to get the bank to agree not to file the 1099-C and to accept the deed or the short sale price in "full satisfaction" of the mortgage indebtedness. Depending on the cost of the legal fees to get this result, you may have a small savings over the cost of the taxes.
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Please consult with an attorney in your area. If the home being foreclosed is your principal residence, the cancellation of debt is not taxable as income. Further, I must respectfully disagree with Mr. Fazzio as I do not believe a bank can agree not to file a 1099C as it is required by law for any business or individual that is in the practice of lending to file the paperwork anytime a debt is cancelled or forgiven.
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