Foreclosure and Taxes: What You Need to Know

Although there may be stress associated with a home foreclosure, you may find some relief when it comes to how forgiven debt is taxed.

Most of the time, the bank decides to foreclose on a home when the homeowner no longer has the ability to continue making payments on the mortgage. When the bank takes possession of the home, this transfer is viewed by the government as a sale of the property for the amount of the remaining debt.

After the completion of the foreclosure process, your debt from the house has now been cancelled. So now what? What about my taxes?

Years ago, debt that was cancelled on your principal residence due to foreclosure or short sale had to be reported as income, however now thanks to the passage and extension of the Mortgage Forgiveness Debt Relief Act, your cancelled debt is not included in your income.  Currently the Mortgage Forgiveness Debt Relief Act has been extended through 2016 but may be good thru 2017, as long as the paperwork began in, or prior to, 2016.

The Mortgage Forgiveness Debt Relief Act generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief.

Cancelled debt on an income property, however would be included in your income, but may be excluded if you are insolvent.

The Restructure Option

Although it may be a long-shot, in some cases the bank will agree to restructure your home loan and reduce the amount that you owe. In this scenario, you can avoid the foreclosure process, reduce your debt, and keep your home if your bank is willing to negotiate with you.

And here is another added benefit, the IRS does not view the reduction in your loan principal as income, so there may be no taxes on the amount reduced.

Here’s some good news at the end of a dark tunnel, using TurboTax will help you confirm whether or not your situation qualifies for any foreclosure-related tax exceptions or exclusions.