It's tax time (groan). If you, like many folks, went through foreclosure in 2010, you will have to deal with it when you file your 2010 return.

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Why might a foreclosure add to your taxable income?

 

When you take out a loan, you get money (or in the case of a mortgage you get a home instead of money), but the money isn't taxed the way it would be if you earned it at your job. That's because you are are supposed to pay it back. But if a lender cancels your debt, the money received becomes taxable income to you. Unless it doesn't -- the IRS loves to make things complicated, so we're going to try and make it easier.

If you lost your primary home to foreclosure, you probably owe no taxes.

 

That's because the Mortgage Forgiveness Debt Relief Act of 2007 lets those who lost homes during the housing crisis exclude up to $2 million of forgiven mortgage debt ($1 million if married filing separately) from taxable income. It applies to foreclosures occurring from 2007 through 2012. In addition, the act protects those whose debt was lessened through mortgage modification. Freebie! Any Pay-for-Performance Success Payments that reduce the principal balance of your mortgage under the Home Affordable Modification Program are not taxable.

Warning! The exclusion doesn't apply "in cases where the reason for foreclosure is not directly related to a decline in the home's value or your financial condition." And it only applies to debt used to "buy, build, or substantially improve" your home. Home equity debt for anything but the purchase or improvement of your home is NOT covered under the exclusion.

If you lost a vacation or rental property, you probably owe taxes.

 

Foreclosure of investment property or vacation home

If you let investment property go into foreclosure, you could be on the hook for income tax. You probably received a 1099-C, Income from Cancellation of Debt. But even if you don't get this form, you have to report debt cancellation income unless:

  • The debt was included in a bankruptcy filing (attach Form 982)
  • You were insolvent to an extent greater than the amount of your taxable gain at the time of foreclosure (meaning your liabilities exceeded your assets by more than you gained from the foreclosure; use Form 982)
  • The foreclosed property is a "qualified farm," meaning that 50% of your gross receipts come from the farm
  • The foreclosure property was used in a trade or business

 

Get professional help.

Foreclosure can turn a simple tax return into a complicated business. Your best bet if you receive a 1099-C or lost investment or vacation property to foreclosure is to find a good tax professional, or at least a good tax software program.