By law, any type of debt forgiveness is a financial benefit, even if it comes at the expense of your home. Since foreclosure usually results in the bank writing off some or all of your mortgage debt, you pay income tax on the dollar value of the canceled debt. In addition, the Internal Revenue Service treats foreclosures as the sale of property, which may result in a capital loss or gain. Failing to report these financial events can result in penalties, fines, interest payments and criminal penalties for fraud.
If the lender cancels mortgage debt, you must declare the forgiveness as income unless an exception applies. The lender issues Form 1099-C, which shows the amount of debt the lender writes off during the tax year. Mortgage debt forgiven between 2007 and 2013 qualifies for an exemption that allows homeowners to ignore the first $2 million of canceled debt on their principal residence. This tax break expired on Dec. 31, 2013, so debt forgiveness after this date must be reported.
Capital Gains Tax
The IRS treats foreclosure as a property sale. If the sale price exceeds the purchase price, you may have to pay tax on the capital gain. For foreclosed property, the sale price is either the fair market value of the property or the outstanding balance of the loan at the time of foreclosure, depending on where you live and the type of loan. Your bank issues Form 1099-A, which contains the information you need when reporting any capital gain income related to the foreclosure. If the foreclosed property is your primary residence, you may be able to discount up to $250,000 of gain from your income.
Civil penalties -- fees, fines and interest -- apply if you fail to record a taxable transaction, understate your income or otherwise file an inaccurate return. Fees can be high, and they get higher as time goes on. The late-filing fee, for example, amounts to 5 percent of your tax liability for each month a return is late, with a maximum of 25 percent. The IRS may apply the late-filing fee in relation to the foreclosure data omitted from your return. Accuracy-related penalties of up to 20 percent may be levied on any income you understate, either negligently or by disregarding IRS rules.
If the IRS suspects fraud -- the deliberate filing of a false return -- it can levy a fraud penalty of 75 percent of the tax underpayment. Worse, the IRS may pursue you through the criminal courts. Criminal charges include tax evasion, the willful failure to file a return or pay taxes, fraud, making false statements and filing a fraudulent return. If convicted of criminal charges, you could spend time in jail.
A former real estate lawyer, Jayne Thompson writes about law, business and corporate communications, drawing on 17 years’ experience in the legal sector. She holds a Bachelor of Laws from the University of Birmingham and a Masters in International Law from the University of East London.