If you lose your home in a foreclosure, there may be tax consequences. These can include a cancellation of the debt income and a gain from the disposal of the home. Both are potentially taxable because the Internal Revenue Service (IRS) regards foreclosures as sales for the purpose of taxation. Any taxable income can be paid by an installment agreement with the IRS. Some eligible taxpayers may be able to settle their debt for a lesser amount.

The Cancellation of Debt Income

When your home loan is cancelled or forgiven by a commercial lender, the amount of your debt income is considered taxable income. That figure becomes income because you are no longer required to pay it back to the lender. The 1099-C (Cancellation of Debt) form will be sent to you and to the Internal Revenue Service by the lender with the amount of cancelled debt and other related information. The only time cancellation of debt income is not taxable is with a non-recourse loan, because you have gained no income with this type of loan. A non-recourse loan is a mortgage where the lender can only foreclose and repossess the property being financed or used as collateral in the case of default and the borrower has no other liability.

Calculating Cancellation of Debt Income

To determine the amount of income remaining on your debt after foreclosure, you begin with the amount remaining on your loan before your home underwent foreclosure. Box seven on Form 1099-C will contain the fair market value of your property. Subtract fair market value from your remaining loan amount. This figure will represent your taxable debt income and must be entered on Form 1040, Line 21.

Gain from the Disposition of the Home

Because the Internal Revenue Service considers your remaining debt taxable income after a foreclosure, there is often a reportable gain. While the gain is considered taxable income, there is a capital gain exclusion that can reduce the amount owed. If you made the home in question your primary residence for at least two years of the last five years before foreclosure and meet other criteria, you can exclude up to $250,000 (if filing alone) or $500,000 (if filing jointly) from the debt taxable income.

Calculating Gain from Foreclosure

Begin with the fair market value of the home. Calculate the adjusted basis, which includes the amount you originally paid and the costs of any major improvements. Subtract the adjusted basis from the fair market value. The resulting figure is the amount you gained when your home underwent foreclosure and is subject to taxation after the capital gain exclusion.

Calculating Gain from Foreclosure for Non-Recourse Loans

While you have gained no debt income from foreclosing on a non-recourse loan, you are still responsible for income gained from the foreclosure because all foreclosures are treated like sales for federal tax purposes. To calculate your gain from foreclosure on a non-recourse loan, begin with the debt amount accrued when the property underwent foreclosure. Calculate the adjusted basis, which includes the home's original purchase price and the amount of any major improvements. Subtract the adjusted basis from the debt amount to figure out the amount gained after foreclosure, which is taxable after the capital gain exclusion.

The Mortgage Forgiveness Debt Relief Act of 2007

This law provides a means for taxpayers to exclude the income related from the discharge of their debt only from the mortgage of their primary residence. The debt may be forgiven in 2007, 2008, or 2009, in the amount of one million dollars if filing as single or two million dollars if filing jointly. The excluded amount will result in the reduction of your cost basis in your home, but only if the loan is backed by the property you live in.

Paying Your Foreclosure-Related Tax Debt

If you still owe additional tax on your foreclosure-related debt, you have some recourse. You can:

• request an installment agreement with the Internal Revenue Service to make monthly payments on your debt.
• determine if you qualify to pay a lesser amount via a settlement on your tax debt using an offer-in-compromise.

Exceptions and Limitations

Borrowers who are insolvent and have lost their homes to foreclosure might fall under a special provision in the tax code. If your liabilities exceed your assets, the remaining taxable income might be offset under this rule. However, if all or part of your home was used at any point for a business or a rental property, tax relief might be limited or unavailable. Debt related to second homes or vacation homes that have been lost in foreclosure is also generally unavailable for any tax relief.

Additional Resources

• Center for Responsible Lending:            http://www.responsiblelending.org
• Home Loan Learning Center:                  http://www.homeloanlearningcenter.com
• Homeowner Crisis Resource Center:       http://www.HousingHelpNow.org
• Internal Revenue Service:                       http://www.irs.gov