Foreclosures and Cancellation of Debt

Are there any tax consequences?

To someone saddled with a huge mortgage or a crushing amount of credit card debt, the opportunity to walk away from the obligation due to a foreclosure or to accept a creditors offer to “cancel” some or all of the debt can seem very enticing. However, the law doesn't let you escape quite that easily.

If you lose your house in foreclosure, there may be some tax consequences. The foreclosure will be treated as a sale on your tax return. If you were “personally liable” for the debt (which is true for most mortgages and home equity debt), you must report a sale for the lesser of the debt outstanding or the fair market value on the date of foreclosure. (If you were not personally liable, the sales price equals the debt outstanding.) As such, the “sale” due to the foreclosure may mean you will have to pay additional tax.

There are some circumstances where tax can be avoided. For example, if you owned and used the home as your principal residence for at least two of the five years ending on the date of foreclosure, you can exclude up to $250,000 ($500,000 on a joint return) of any gain on the sale. However, any loss on the sale is a nondeductible personal loss.

You may also have additional taxable income if a lender cancels debt exceeding the fair market value of your house. In general, such cancellation of debt income is taxable. However, if you were insolvent or bankrupt and the debt was related to your principal residence, you may be able to exclude some of the cancelled debt from your tax return.

Only debt incurred to acquire, construct, or substantially improve your principal residence can qualify for the principal residence exclusion. If you used a home equity loan to pay off credit card debt, for example, that portion of the loan does not qualify. In this case, the amount that may be excluded from income is limited to the amount canceled over the amount that is not qualified principal residence indebtedness. (The balance of the debt, however, may still qualify for the insolvency or bankruptcy exception.)

The cancellation of other types of debt, such as credit card debt, generally ALWAYS results in taxable income to you. Make sure you understand the tax implications before you accept such an offer.

As always, our tax professionals are available to answer any questions you may have. Please contact our office.

(June 14, 2010)

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