When consumers lose their homes through foreclosure, there are two possible tax consequences to consider:

• Taxable cancellation of debt income
• Reportable gain from the disposition of the home (foreclosures are treated like sales for tax purposes)

Cancellation of debt 

If a lender cancels or forgives a consumer’s debt for money that had been borrowed, the borrower may have to include the cancelled amount as income for tax purposes. When the loan was originated the borrower was not required to include the loan proceeds in income because there was an obligation to repay. When that obligation is subsequently forgiven, the amount received as loan proceeds is reportable as income on Form 1099-C, Cancellation of Debt.

Is cancellation of cebt income always taxable? 

Not always. This is determined on the IRS Form 982, which the IRS has just revised. See the form online at: www.irs.gov/pub/irs-pdf/f982.pdf.

Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.

Insolvency: If the borrower is insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable. A borrower is insolvent when total debts are more than the fair market value of total assets. This may be determined using Form 433F, “Collection Information Statement,” available at www.irs.gov, but the assistance of a tax professional is recommended.

Mortgage Forgiveness Debt Relief Act of 2007: The Act generally allows taxpayers to exclude income from the 2007, 2008 or 2009 discharge of acquisition debt (purchase, building and improvement costs) incurred on their principal residence, but not on second homes or investment properties. The Act helps homeowners facing foreclosures or who sell their homes in a short sale by excluding up to $2 million of forgiven debt ($1 million if married, filing separately) provided the discharge is due to the decline in the home’s value or the taxpayer’s financial condition.

Lenders must send Form 1099-A, Acquisition or Abandonment of Secured Property, to borrowers if there is a foreclosure or deed in lieu of foreclosure, or a Form 1099-C, Cancellation of Debt, which reports the amount of debt forgiven. What is important is that the form received accurately states the fair market value (FMV) of the property. For a foreclosure, the winning gross foreclosure bid is considered to be the FMV; for a short sale, it is the sales price; and for a deed in lieu of foreclosure, the appraised value of the property should be used.

Hypothetical: A borrower bought a home in August 2005 and lived in it until it was taken through foreclosure in September 2007. The original purchase price was $170,000, the home is worth $200,000 at foreclosure, and the mortgage debt canceled is $220,000 (borrower refinanced for home improvements). At the time of foreclosure, the borrower is insolvent, with liabilities (mortgage, credit cards, car loans and other debts) totaling $250,000 and assets totaling $230,000.

Figuring cancellation of debt income 

Deduct the FMV from the total debt outstanding immediately before the foreclosure:

$220,000 - $200,000 = $20,000

This amount generally will match the amount shown in Box 2 of Form 1099-C. This amount would have been taxable except for the fact that this borrower appears to meet two exemptions: both the Mortgage Forgiveness Debt Relief Act of 2007 and the fact that she is insolvent save the borrower from paying income tax on the cancellation of the debt income of $20,000.

Figuring gain from foreclosure 

Deduct the adjusted basis in the property (usually the purchase price plus the cost of major improvements) from the FMV: $200,000 - $170,000 = $30,000.

Because the borrower owned and used the home as her principal residence for periods totaling at least two years during the five-year period ending on the date of the foreclosure, she may exclude up to $250,000 in gain (up to $500,000 for married couples filing a joint return) from income.

Although mortgage workouts and foreclosures can have tax consequences, special relief provisions can often reduce or eliminate the tax bite for financially strapped borrowers who lose their homes due to foreclosure. Anyone facing foreclosure should always consult with a tax professional for an evaluation of his or her personal circumstances.

See www.irs.gov/irs/article/0,,id=179073,00.html for additional information and resources.

Debbi Conrad is Director of Legal Affairs for the WRA.