Tax Consequences of Foreclosure

The American dream is to own you own “Home Sweet Home.” Sometimes the American dream can turn into a nightmare when homeowners face financial difficulties that make it impossible for them to stay current on their mortgage payments. As a result the bank forecloses on the property, the homeowner is evicted and their credit is destroyed. Just when you think matters could not get any worse, the IRS will show up and slap the downtrodden owner with a tax bill for the cost of the foreclosure. And we all know the IRS can squeeze blood from a turnip.

Let me give you an example of what might happen if your home is foreclosed. You purchase a house for $100,000 and have a mortgage for $90,000. Two years later the home is foreclosed on after you have made a total of $5,000 in mortgage payments. The $85,000 of the loan that you did not pay is considered as income by the IRS and they expect you to pay taxes on this amount!

With the recent downturn of the housing market over the past couple of years, more than 1 million homes nationwide are in some stage of foreclosure. To aid homeowners President Bush in 2007 signed into law the “Mortgage Forgiveness Debt Relief Act of 2007.” This law protects homeowners from being taxed as a result of losing their primary residence to foreclosure.

The Mortgage Forgiveness Debt Relief Act of 2007 offers homeowners an exclusion of income from the discharge of debt when their principal residence is foreclosed. The amount that can be excluded is based on your filing status with single taxpayer and married filing separately can exclude up to $1 million and taxpayers filing jointly can exclude up to $2 million. The only catch is that law only applies to foreclosures that occur between 2007 and 2012.

The Mortgage Forgiveness Debt Relief Act only applies to primary residences. It does not apply to rental properties or second homes. If you refinance your primary residence during the time this law in effect, the exclusion only applies to the amount of the mortgage that was refinanced.

What do homeowners do if the amount of forgiven debt exceeds the amount they are allowed to exclude? Well they can always pay taxes on the difference. Another option is to declare bankruptcy and have the debt discharged with the bankruptcy. Debts discharged in bankruptcy are not considered taxable income. The last option to avoid paying taxes would be to show that the homeowner is insolvent. To do this you would have to show that the amount of your debts exceed the amount of your assets.

Losing a home to foreclosure can be a traumatic event. Being stuck with a tax bill can make things even worse. Thanks to recent legislation most homeowners should not get a notice from the IRS after losing a home to foreclosure.