Federal tax law says that if your creditors forgive your debt, that's the same as earning extra income. Up until 2007, that included any part of your mortgage debt your lender forgave after foreclosure. A 2007 federal law changed that rule -- but the law, at the time of writing, is set to expire at the end of 2012.
Sometimes the foreclosure sale of your home doesn't pay off your mortgage debt. Depending on your state law, your lender may be able to sue you for the rest of the money. If your home is worth less than the mortgage, some states only let lenders recover the difference between the home's value and the sale price. If the lender decides not to sue, the unpaid debt is taxable income. In states that don't allow deficiency lawsuits, the money is not taxable.
Mortgage Debt Relief Forgiveness Act
The federal Mortgage Debt Relief Forgiveness Act exempts you from paying taxes on up to $1 million of unpaid mortgage debt, or $2 million for joint filers. It only applies to your primary residence -- if the bank forecloses on rental property or your vacation home, you're still on the hook -- but it includes refis as well as the original mortgage. You still have to report forgiven debt on your income taxes, using form 982. Your lender will send you a form telling you how much debt you have to report to the IRS.
The act applies to mortgage debt forgiven from 2007 to the end of 2012. Starting Jan. 1, 2013, forgiven mortgage debt becomes taxable again unless Congress votes to renew the law. Real estate and housing lobbyists are pushing strongly for renewal out of fears that expiration will hurt the housing market. On the other hand, "The Seattle Times" reports that a number of legislators object to the law as a "bailout" for irresponsible homeowners and would sooner see it die.
Even without the Forgiveness Act, there are ways you can protect yourself from paying extra taxes on top of losing your house. If you can prove you're insolvent -- your total debts are greater than your total assets -- the IRS won't expect taxes on any forgiven debts. If you file bankruptcy, none of the debts bankruptcy wipes out are taxable. Bankruptcy can't get rid of a mortgage debt, but it can eliminate a deficiency after foreclosure.
- Nolo: Deficiency Judgments: Will You Still Owe Money After the Foreclosure?
- IRS.gov: Home Foreclosure and Debt Cancellation
- IRS.gov: The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
- Seattle Times: Mortgage Relief Faces a Tax-Law Nightmare
- IRS.gov: Canceled Debt, Foreclosures, Repossessions and Abandonment