Losing your home is bad enough, but depending on the type of loan you had, your personal financial situation, and how much the lender eventually sold your home for, you could end up owing taxes related to the foreclosure or short sale of your home.
That’s because to the IRS, a foreclosure or short sale is still a transaction in which real estate has changed hands.
If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances.
When you initiated your mortgage, the money the lender gave you to buy your home wasn’t considered income because you were expected to repay the money. When that obligation is subsequently forgiven, the amount you received as loan proceeds is reportable as income because you no longer have an obligation to repay the lender.
Mortgages are generally recourse debts, means the borrower is personally liable for the debt, and the lender has the right to collect what is owed for the debt even after they’ve taken possession of the collateral. The IRS treats the foreclosure on a recourse debt as if you sold the property yourself. The gain or loss on the disposition of the property is the difference between the fair market value (FMV) of the property at the time of the disposition and your adjusted basis (usually your cost) in the property.
The character of the gain or loss (such as ordinary or capital) is determined by the character of the property. If the lender forgives all or part of the amount of the debt in excess of the FMV of the property, the cancellation of the excess debt may result in ordinary income. The ordinary income from the cancellation of debt (the difference between the canceled debt amount and the FMV of the property) must be included in your gross income reported on your tax return unless one of the exceptions or exclusions applies. In some circumstances, the cancellation of debt through a foreclosure may not be taxable income. For example, debts discharged through bankruptcy are not considered taxable income.
IRS Publication 4681 provides information about the tax impact of canceled debts, foreclosures, repossessions and abandonments for individuals, as well as worksheets to help you understand the potential tax impact.