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You are here: Home  IRS   Tax Consequences

Federal Income Tax Consequences of Home Foreclosures & Cancellation of Indebtedness

If your lender forecloses on real property that is encumbered by a lien that secures payment of a promissory note, you may have to report income from the transaction on your federal income tax return.  Whether you will have taxable income depends on the facts and circumstances of your particular situation.  This article explains a federal income tax law known as "cancellation of indebtedness income."  In general, if you owe money and all or portion of the debt becomes legally uncollectible, you have to report the amount of the debt that is discharged as income on your federal income tax return.  This is called cancellation of indebtedness income.

Mortgage Forgiveness Debt Relief Act of 2007

The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007 (see News Release IR-2008-17).  Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence.  The Mortgage Forgiveness Debt Relief Act may give a taxpayer relief from the income tax consequences discussed below.  For more on the MFDRA, see the MFDRA Frequently Asked Questions.

Cancellation of Indebtedness (Debt)

If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for income tax purposes, depending on the circumstances.  When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender.  When that obligation is forgiven or discharged and no longer collectible, the amount you received as loan proceeds is reportable as income because you no longer have an obligation to repay the lender.  The lender is usually required to report the amount of the canceled debt to you and the IRS on an IRS Form 1099-C, Cancellation of Debt.

Here’s a very simplified example. You borrow $10,000 and default on the loan after paying back $2,000.  If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you.

Exceptions to the Cancellation of Debt Income Law

Cancellation of debt does not always cause discharge of indebtedness income.  There are some exceptions.  The most common situations when cancellation of debt income is not taxable involve:

  • Bankruptcy:  Debts discharged through bankruptcy are not considered taxable income.

  • Insolvency:  If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you.  You are insolvent when your total debts are more than the fair market value of your total assets.  Insolvency can be fairly complex to determine and the assistance of a tax professional is recommended if you believe you qualify for this exception.

  • Certain Farm Debts:  If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.  The rules applicable to farmers are complex and the assistance of a tax professional is recommended if you believe you qualify for this exception.

  • Non-recourse Loans:  A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral.  That is, the lender cannot pursue you personally in case of default.  Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income.  However, it may result in other tax consequences, as discussed in in the next section.

The Tax Consequences of Losing a Home Through Foreclosure

If you lose your home through a foreclosure, there are two possible consequences you must consider: 

  • Taxable cancellation of debt income.  As stated above, cancellation of debt income is not taxable in the case of non-recourse loans.

  • A reportable gain from the disposition of the home because foreclosures are treated like sales for tax purposes.  Often some or all of the gain from the sale of a personal residence qualifies for exclusion from income.

Use the following steps to compute the income to be reported from a foreclosure:

Step 1 - Figuring Cancellation of Debt Income.  For non-recourse loans, skip this section.  You have no income from cancellation of debt.

  1. Enter the total amount of the debt immediately before the foreclosure.  ___________

  2. Enter the fair market value of the property from IRS Form 1099-C, box 7.  ___________

  3. Subtract line 2 from line 1.  If less than zero, enter zero. ___________

The amount on line 3 will generally equal the amount shown in box 2 of IRS Form 1099-C.  This amount is taxable unless you meet one of the exceptions noted above.  Enter the amount on line 3 above on line 21, Other Income, of your IRS Form 1040.

Step 2 – Figuring Gain from Foreclosure

  1. Enter the fair market value of the property foreclosed.  For non-recourse loans, enter the amount of the debt immediately prior to the foreclosure.  ________

  2. Enter your adjusted basis in the property.  Usually your purchase price plus the cost of any major improvements. ____________

  3. Subtract line 5 from line 4.  If less than zero, enter zero.   

The amount on line 3 is your gain from the foreclosure of your home.  If you have owned and used the home as your principal residence for periods totaling at least two years during the five year period ending on the date of the foreclosure, you may exclude up to $250,000 (up to $500,000 for married couples filing a joint return) from income.  If you do not qualify for this exclusion, or your gain exceeds $250,000 ($500,000 for married couples filing a joint return), report the taxable amount on Schedule D, Capital Gains and Losses of your IRS Form 1040.

Loss on Foreclosure of Home Not Deductible

If you lose your home through a foreclosure and it produces a loss rather than a gain or taxable income, you cannot deduct the losses on your federal income tax return.  Losses from the sale or foreclosure of personal property are not deductible.

Examples

A borrower bought a home in August 2005 and lived in it until it was lost through a foreclosure in September 2007. The original purchase price was $170,000, the home is worth $200,000 at foreclosure, and the mortgage debt canceled at foreclosure is $220,000. At the time of the foreclosure, the borrower is insolvent, with liabilities (mortgage, credit cards, car loans and other debts) totaling $250,000 and assets totaling $230,000.

The borrower figures income from the foreclosure as follows:

Use the following steps to compute the income to be reported from a foreclosure:

Step 1 - Figuring Cancellation of Debt Income For non-recourse loans, skip this section.  You have no income from cancellation of debt.

  1. Enter the total amount of the debt immediately before the foreclosure.  $220,000

  2. Enter the fair market value of the property from IRS Form 1099-C, box 7.  $200,000

  3. Subtract line 2 from line 1.  If less than zero, enter zero.  $20,000

The amount on line 3 will generally equal the amount shown in box 2 of IRS Form 1099-C.  This amount is taxable unless you meet one of the exceptions listed above.  Enter the amount on line 3 on line 21, Other Income, of your IRS Form 1040.

Step 2 – Figuring Gain from Foreclosure

  1. Enter the fair market value of the property foreclosed.  For non-recourse loans, enter the amount of the debt immediately prior to the foreclosure.  $200,000

  2. Enter your adjusted basis in the property.  Usually your purchase price plus the cost of any major improvements. $170,000

  3. Subtract line 5 from line 4.  If less than zero, enter zero.  $30,000   

The amount on line 6 is your gain from the foreclosure of your home.  If you have owned and used the home as your principal residence for periods totaling at least two years during the five year period ending on the date of the foreclosure, you may exclude up to $250,000 (up to $500,000 for married couples filing a joint return) from income.  If you do not qualify for this exclusion, or your gain exceeds $250,000 ($500,000 for married couples filing a joint return), report the taxable amount on Schedule D, Capital Gains and Losses, on your IRS Form 1040.

In this situation, the borrower has a tax-free home-sale gain of $30,000 ($200,000 minus $170,000), because they owned and lived in their home as a principal residence for at least two years.  Ordinarily, the borrower would also have taxable debt-forgiveness income of $20,000 ($220,000 minus $200,000). But since the borrower’s liabilities exceed assets by $20,000 ($250,000 minus $230,000) there is no tax on the canceled debt.

Other examples can be found in IRS Publication 544, Sales and Other Dispositions of Assets, under the section “Foreclosures and Repossessions”.

What to Do If You Don’t Agree with IRS Form 1099-C

Contact the lender.  The lender should issue a corrected form if the information is determined to be incorrect.  Retain all records related to the purchase of your home and all related debt.

What Should You Do If the IRS Sends You a Notice After a Foreclosure?

The IRS urges borrowers with questions to call the phone number shown on the notice.  The IRS also urges borrowers who wind up owing additional tax and are unable to pay it in full to use the installment agreement form, normally included with the notice, to request a payment agreement with the agency.

This article is current as of September 20, 2007.

Schedule an Arizona Foreclosure Law Consultation

If you have questions about Arizona foreclosure law and the legal consequences of defaulting on a loan secured by a lien on an Arizona home, hire Arizona real estate attorney Jeana Morrissey to review your loan situation and answer your questions.  Jeana offers a one hour in office or over the phone consultation for $349.  Contact Jeana at 602-906-4953 ext. 4 or jrm@keytlaw.com. To hire Jeana, complete our online consultation agreement.  To schedule a consultation, call Jeana's legal assistant Milena at 602-424-4159.

Circular 230 Notice:  Pursuant to U.S. Treasury Department regulations, I am required to advise you that, unless otherwise expressly indicated, any federal tax advice contained in this communication, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

Schedule an Arizona Foreclosure Law Consultation

If you have questions about Arizona foreclosure law and the legal consequences of defaulting on a loan secured by a lien on an Arizona home, hire Arizona real estate attorney Jeana Morrissey to review your loan situation and answer your questions.  Jeana offers a one hour in office or over the phone consultation for $349.  Contact Jeana at 602-906-4953 ext. 4 or jrm@keytlaw.com. To hire Jeana, complete our online consultation agreement.  To schedule a consultation, call Jeana's legal assistant Milena at 602-424-4159.

 

This page was last modified on October 10, 2011.

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