The Tax Consequences of Foreclosure

Homeowners who have lost their home to foreclosure may be in for an unpleasant surprise. Many think that just because the bank has foreclosed on their home that their financial woes are behind them and their mortgage can no longer hurt them. Unfortunately, this is simply not the case for all homeowners. The Internal Revenue Service has several rules that apply to homes lost to foreclosure. Some of the tax consequences of foreclosure include:

Inability to deduct interest

For the homeowner who lost their home to foreclosure, they will not be able to deduct any interest they paid towards their mortgage during the tax year. For many homeowners, this can be a substantial loss of deductions on their tax returns meaning they will likely have a larger liability.

The 1099C

Foreclosures result in cancellation of debt. Homeowners who have had their primary residence foreclosed on will likely receive a Form 1099C in the mail. Form 1099C is called “Cancellation of Debt” and lenders will provide this form for debt that was forgiven if it was above $600.  For most homeowners, however, this may not be problematic.

The Internal Revenue Service website states “The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. This provision applies to debt forgiven in calendar years 2007 through 2012.”

The exceptions to Mortgage Debt Relief Act of 2007 may include:

• Second homes – the loss of a second home may not be eligible for the debt exclusion offered by the IRS. There are specific cases where they may apply; most will not;

• Not related to value – if the foreclosure is not a result of the decline in  real estate values the debt may not be eligible for exclusion. For example, if a home is valued the same as it always was and the homeowner suffered a mortgage rate spike because they had an adjustable mortgage, there will be no exclusion allowed;

• Second mortgages – a homeowner who has had a second mortgage or home equity loan that was discharged may not be eligible for the debt exclusion provision. Most exclusions apply only to first mortgages and most likely to the mortgage that was used to purchase the home depending on the circumstances of the refinance;

• High value homes – there are limits set by the Internal Revenue Service which must be reviewed for exclusions, especially for those who had high value homes.  High value homes are set by each jurisdiction so homeowner’s will have to review them;

For any homeowner who has had to deal with the foreclosure process during the tax year, it is highly recommended they contact a qualified tax preparer. The tax implications of losing a home to foreclosure are numerous and failure to properly fill out the required forms or claim the proper amounts could result in an audit.

Helpful additional reading:

Tax Consequences of a Foreclosed House