How does foreclosure affect taxes?

By Gina Pogol
Mortgage Credit Problems Columnist

Dear Gina, I had an investment property with a bad credit home loan. The rents did not cover the payment, and when I lost my job I had to let the property go into foreclosure. I just received a tax form saying that I owe taxes on $78,000 from the foreclosure! No one I know with a foreclosure had to pay tax! What gives? - Karen, Greensboro, N.C.

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Dear Karen,

It's bad enough to have unemployment and credit problems, but foreclosure can cause tax problems too. That form you received is a 1099-C, and it reports income from the cancellation of debt.

How a foreclosure becomes income

When you take out a bad credit mortgage or any kind of loan, you receive money. That money is not considered taxable income because you are supposed to pay it back. However, if you don't pay it back and the lender cancels your obligation, your loan proceeds become taxable, according to legal self-help publisher Nolo Press.

However, foreclosure of primary residence is not (usually) taxable. Most people who go through foreclosure don't get taxed on the loan proceeds as long as the home they lose is their primary residence. The Mortgage Forgiveness Debt Relief Act of 2007 exempted those who lost homes during the housing crisis between 2007 and 2012, according to the Internal Revenue Service (IRS). In addition, the act protects those whose mortgage balance was reduced by a mortgage modification.

However, your foreclosure income is taxable because your property was a rental.

Ways to avoid income tax on foreclosure property

If you had to let investment property or a vacation home go because of financial problems, you will probably get a 1099-C, Income from Cancellation of Debt. Even if you don't get the dreaded form, you have to report the income.

There are exceptions, though. You don't report this income if any of the four following conditions are true:

  1. The debt was included in a bankruptcy filing (attach IRS Form 982).
  2. You were insolvent to an extent greater than the amount of your taxable gain at the time of foreclosure (use IRS Form 982).
  3. The foreclosed property is a "qualified farm," meaning that 50 percent of your gross receipts come from the farm.
  4. The foreclosure property was used in a trade or business.

The IRS has an insolvency worksheet you can use to determine how much, if any, or your foreclosure-related gain is taxable. The short answer is that you subtract your assets from your liabilities. That determines how much of your taxable gain can be excluded.

For example, if you have $200,000 in debts and only $150,000 in assets, you are insolvent to the extent of $50,000 ($200,000 - $150,000). That means that you can exclude up to $50,000 of gain from your foreclosure from taxes.

Get professional tax help

Foreclosure can throw a monkey wrench into your tax filing. Your best bet if you receive a 1099-C or lose investment or vacation property to foreclosure is to hire a good tax pro or, at the very least, buy some good tax software.

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