If you are subjected to a deficiency judgment after foreclosure (i.e. the monetary difference between what you owe and the price the bank sells the home for), it's possible to negotiate with the lender and get it to forgive some or all the debt. However, that can be the start of a whole new problem where the IRS demands you pay taxes on the forgiven debt. Here's more information about this issue and your options for dealing with it.
Cancelled Debt is Considered Income
It may seem odd you would have to pay tax on debt that was written off by the lender. However, the IRS views this cancelled debt as income. That's because you received money from the lender you were supposed to pay back. Since you no longer have to repay that amount, it's as if the lender cut you a check for free money. As such, the IRS counts that as income, and you are required to pay taxes on it.
This rule applies to all debt, not just mortgage forgiveness. There are some exceptions, though. You won't have to pay taxes on the debt if
- It was discharged via bankruptcy
- Your debts outpaced your assets at the time the debt was cancelled (i.e. insolvent)
- The mortgage was a non-recourse loan where the lender was barred from collecting the mortgage deficiency
- The debt arose due to the operation of a farm
If none of these apply to you, you're required to report the forgiven debt on your taxes in the year it was cancelled.
Avoiding the Tax Fallout
There are a couple of ways you can avoid this issue. The first is to take advantage of the Mortgage Forgiveness Debt Act. This act previously expired in 2014, but was extended two more years to cover foreclosures in 2015 and 2016. Through this temporary law, you can exclude up to $2 million dollars in forgiven mortgage debt as long as the loan was for your primary residence. Unfortunately, the law doesn't cover mortgages on second homes, rental property, or business property.
The other option to avoiding the tax hit is to file for bankruptcy. There are two ways this can help. As mentioned previously, debts discharged through bankruptcy are non-taxable, so you'll get rid of the deficiency judgment as well as the tax liability.
Alternatively, federal income tax can be discharged through a chapter 7 bankruptcy. The caveat here, though, is the debt must be a minimum of 3 years old and had to have been assessed at least 240 days before you file for bankruptcy.
It's important to consult an attorney about these issues to avoid taking steps that may make things worse. For more information about the tax consequences of mortgage forgiveness or help with your case, contact a lawyer, like one from Hamby & Hamby, P.A.