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).
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:
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.
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.
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.