As with most items surrounding a foreclosure there can be some great confusion when it comes to the various forms and paperwork that need to be filled out to make sure you are fulfilling all of your tax obligations.  An important thing to remember when any bank cancels your mortgage debt is that anytime there is a cancellation of any debt this may result in taxable income.

Since a foreclosure is viewed as a sale of property, and if this real estate foreclosure results in a cancellation of debt, then that foreclosure may be a taxable event.  Of course with any tax matters and especially ones surrounding foreclosures there are certain exceptions to the rule.

First, if the property lost in foreclosure is your primary residence then the cancellation of debt generally will not be taxable.  This is a direct result of the Mortgage Forgiveness Debt Relief Act of 2007.  While this may be true on a federal level it might not be the case on a state level.  It is best to consult any state laws that may overrule the Mortgage Forgiveness Debt Relief Act.

From the state of California:

Second, in California, purchase money home loans are generally treated as non-recourse debt. If the bank forecloses on a non-recourse mortgage, then the homeowner is treated as having sold the home for the amount of the outstanding debt. The difference between the outstanding debt and the homeowner’s adjusted basis in the house is considered a gain or loss on the sale of the home. If the home is the taxpayer’s principal residence, where they have lived for at least two of the past five years, the gain may be eligible for the gain exclusion on the sale of a principal residence. If the foreclosure results in a loss, the loss may not be taken since it resulted from the sale of a principal residence.

Third, if you are insolvent at the time the debt is cancelled then you will not be taxed.  To be considered insolvent your liabilities must exceed your assets.  You will be required to submit IRS form 982 with your tax return to demonstrate your insolvency but this form could go a long way in helping you save some extra money.

The fourth exception to the rule is that you do not need to pay any taxes if a debt is cancelled because of your filing for bankruptcy.  This may seem like an easy way out of any tax liabilities associated with a cancellation of debt but filing for bankruptcy has many negative effects that far outweigh this one positive.  You must carefully consider all of your options before filing for bankruptcy to relieve yourself of any tax liabilities.

If you do not meet any of the three exceptions then you are going to have to pay taxes on the amount of your cancelled debt.  The form that is most important in this process is the IRS form 1099-C.  It is this form that tells you that the bank has cancelled the debt and therefore officially creates the tax liability. This form can also be used as evidence in a later lawsuit by the lender to refute and allegation that the debt is still due and owning.

As you can see if you are facing the possibility of having to pay taxes on a cancelled debt you really need to be on the lookout for IRS form 1099-C.  It is with this form that the cancellation of debt becomes official and when your tax responsibility kicks in. Also, it is always best to seek out 2-3 qualified tax attorneys to consult with in order to get a true gars of all your legal options.

Moe Bedard
My name is Maurice "Moe" Bedard. I am the founder of America's #1 Mortgage Forum, LoanSafe.org. My online work has been featured in the New York Times, LA Times, Fox Business, and many other media publications.