It’s certainly believable that given the current economic conditions, U.S. home foreclosures increased nearly 22% in 2009. Losing your home is obviously devastating, but there are tax ramifications following a foreclosure which could cause you to owe more money to the Internal Revenue Service (IRS).

The basic tax rule of forgiveness of debt is simple: when a lender cancels your debt, a Form 1099C is issued to you and the IRS for the amount of the debt. The amount of forgiveness is then taxable as ordinary income to you. 

With the Mortgage Forgiveness Debt Relief of 2007, Congress provided homeowners a break, in that the forgiveness of debt on your primary residence is excludable from income. Note that this relief is only available on a primary residence mortgage up to $2 million in debt through 2012. Forgiveness of a mortgage or loan on your vacation home, car or other debt is reported as taxable income to the taxpayer.

Two exceptions can affect the homeowner. If the mortgage (even on your vacation home) is forgiven in bankruptcy, the forgiveness of debt is not taxable income. Also, if you can prove that you’re insolvent, part of the debt may be forgiven. For example, if you have assets of $150,000 and liabilities (debt) of $200,000, then up to $50,000 of your debt forgiveness is tax free. Any excess would be taxable as ordinary income.

Therefore, when you lose your primary residence due to foreclosure, no further tax burden exists on the amount forgiven. However, you should also consider what impact no longer owning a home will have on your tax bill in the future. When owning a home you’re eligible to deduct the mortgage interest paid on principal borrowed to purchase the home and the interest on an additional $100,000 in home equity borrowing. As a homeowner, you also can deduct the real estate taxes paid on the home. 

So, taxpayers who lose homes should do some tax planning to prepare for the impending amount due to the IRS because of the reduction in their itemized deductions. Someone in the 25% tax bracket who in the past could deduct $10,000 in mortgage interest and $3,000 in real estate tax will see an increase in the tax owed of $3,250. If you couldn’t pay your mortgage, chances are you’ll have difficulty paying the IRS the additional taxes.

When a home is lost to foreclosure the taxpayer may also lose the benefit of the homebuyer’s tax credit taken in previous years. First time homeowners in 2008 could take advantage of the Housing and Economic Recovery Act which gave them a refundable credit of 10% of the purchase price, up to $7,500. This credit amount was essentially a loan from the IRS and needed to be repaid beginning in 2010 over 15 years. The American Recovery and Reinvestment Act of 2009 provided a credit of up to $8,000 which did not have to be repaid if you stayed in the home for the next three years. The credits would have to be repaid if your home was foreclosed on in the next 15 years (for a home purchased in 2008) and within three years (for a home bought in 2009 or early 2010).

Losing your home is a terrible problem for many homeowners in the current economy. Homeowners facing foreclosure should be aware of all financial aspects of losing their homes before they start the process. If you still have questions, call us at (904) 396-5400.

Filed under: Tax by Lisa Campbell