Your House is Foreclosed On -- Congrats, You Now Owe More Taxes!

Here's a real kick-them-while-they're-down note from Kiplinger's. They note that under certain circumstances (ones that are not that unlikely to happen), you may owe additional taxes if your house is foreclosed on. The details:

If the bank sells your home for less than the amount left on your mortgage, any forgiven debt can be treated as taxable income. The IRS even has a special form for reporting this windfall: the 1099-C. The C stands for cancellation of debt and the law says cancelled debt is taxable just the same way salary is.

No one ever said that the IRS played nice, but this seems way below the belt. Talk about piling on when someone is down on their luck!

Just one more reason, I guess, to buy a house you can afford -- which is one of the keys in my formula for buying a house.

Comments

[segfault]

My understanding is that you don't have to pay the taxes on cancellation of indebtedness if you're insolvent.

[FMF]

Segfault --

Do you have an article or link that gives more detail on that?

[Dus10]

segfault, this is definitely true. I actually had this happen to me several years back. I did a short-sale of my home to avoid foreclosure, and a couple of years later, the IRS came knocking. I worked with a tax attorney ($500) to get the situation rectified. Spending that $500 saved me about $5k.

[Chris]

You can read more information here

http://www.irs.gov/publications/p17/ch12.html#d0e30347

See the section "Excluded Debt", you are excluded when...

"The debt is canceled when you are insolvent. However, you cannot exclude any amount of canceled debt that is more than the amount by which you are insolvent. See Publication 908"

A link to the referenced publication:

http://www.irs.gov/publications/p908/ar02.html#d0e1058

Specifically:

"Insolvency exclusion. You are insolvent when, and to the extent, your liabilities exceed the fair market value of your assets. Determine your liabilities and the fair market value of your assets immediately before the cancellation of your debt to determine whether or not you are insolvent and the amount by which you are insolvent.

Exclude from your gross income debt canceled when you are insolvent, but only up to the amount by which you are insolvent. However, you must use the amount excluded to reduce certain tax attributes, as explained later under Reduction of Tax Attributes.

Example.

$4000 of the Simpson Corporation's liabilities are cancelled outside bankruptcy. Immediately before the cancellation, the Simpson Corporation's liabilities totaled $21,000 and the fair market value of its assets was $17,500. Because its liabilities were more than its assets, it was insolvent. The amount of the insolvency was $3,500 ($21,000 — $17,500).

The corporation may exclude only $3,500 of the $4,000 debt cancellation from income because that is the amount by which it was insolvent. It must also reduce certain tax attributes by the $3,500 of excluded income. The remaining $500 of canceled debt must be included in income.
"

[Scott Ames]

Leave it to the government to screw over people who are down on their luck.