After going through the pain and humiliation of losing a home through foreclosure, is it possible to end up owing taxes? That seems incredibly unfair, especially with all the tax breaks given to wealthy people. Prior to 2007, this was the stark reality faced by anyone whose home went through foreclosure proceedings.
The reason is that, the way tax laws are written, debt that is cancelled is viewed as income. Therefore, it is taxable. Now, due to the Mortgage Forgiveness Debt Relief Act of 2007, most people who lose a home due to foreclosure will not owe federal income tax on the cancelled debt. The same applies to those who either get the mortgage modified or go into short sale.
There are two possible tax consequences to consider:
Taxable cancellation of debt, which is considered income.
A reportable gain from sale of the house, because foreclosure is treated like a sale for tax purposes.
The Mortgage Forgiveness Debt Relief Act of 2007 usually allows homeowners who go into foreclosure or short sale to exclude the amount of mortgage canceled in this action from federal taxes. This is true only if the house was the primary residence, and the gain is not due to services provided to the lender. It applies only to forgiveness of a mortgage debt incurred because the house lost market value or the home owner was in severe financial straits.
The law applies to nonrecourse loans, those in which the lender cannot go after you personally but only through sale of the property. The provision applies to debt forgiven in the years 2007-2012. You can exclude up to $250,000 ($500,000 for married couples filing a joint tax return) on federal income tax. If your gain exceeds that amount, you will have to report it as income. Exclusions apply only if you lived in the house as your primary residence for at least 2 of the five years leading up to the foreclosure
If the mortgage is a recourse loan, you will need to figure the amount you owe in taxes.
Take the total amount of the debt before foreclosure. Subtract the purchase price plus the cost of any major improvements. This will give you the amount usually shown in box 2 of Form 1099C.
To figure gain from foreclosure, take the fair market value of the property foreclosed and subtract the purchase price plus the cost of major improvements.
The law does not address state income tax, and the states vary widely in their handling of foreclosure. The best advice is to seek the counsel of an attorney if in any doubt, especially in the case of farm property. The rules that apply to farms are too complex for most people to deal with on their own. The Internal Revenue Service maintains a website with information for homeowners facing this dilemma.
If you qualify, they also offer a free Low Income Taxpayer Clinic. To find one in your area, call the Taxpayer Advocate Service at 1-877-777-4778. The Taxpayer Advocate Service may also be able to help you if there is a discrepancy between your records and the amount reported to the IRS by the lender.
Sorry, it does not work the other way. You cannot deduct a loss on the sale of personal property from your income taxes.
References and further information:
http://www.irs.gov/newsroom/article/0,id=174034,00.html