For some struggling homeowners, the taxes on forgiven debt or phantom income are all too real.
"If it's $10,000, that's a relatively small spread; $2,000 to $2,500 in federal and state taxes," says Lanzaro. "But it's not just the working man having this problem. Everybody's getting in over their head these days.
"If you have a $700,000 mortgage and the bank can only get $500,000 in a foreclosure sale, now you're talking about some tax liability."
And don't think the IRS won't find out. The agency
has a mechanism to catch foreclosure sales. The lender is supposed
to issue a 1099-C to alert the former homeowner and IRS of the canceled debt, and,
in certain cases, a 1099-A showing the information you need to figure your gain or loss.
||foreclosure and taxes
"Some people are moving and the 1099 has trouble
catching up," says Gary Garwitz, tax partner with BKD LLP in
Springfield, Mo. "If you're in that situation and had a mortgage
you didn't pay off, make sure you get that 1099."
The IRS definitely will get its copy and expect the associated taxes. If they're not paid, penalties and interest will be added.
Home-sale exclusion opportunity
There is one bit of good news for our hypothetical homeowner and others dealing with foreclosure-induced taxes. You can get out from under at least part of the IRS bill if you meet the homeownership tax-exclusion rules.
This popular tax break allows a single homeowner who sells his property under more favorable circumstances to exclude up to $250,000 profit from taxes; the exclusion is $500,000 for married couples filing jointly.
The exclusion also applies in foreclosures. As long
as the seller, in this case the foreclosed-upon owner,
lived in the home as his principal residence for two of the last
five years, he also can avoid taxes on any capital gain profit,
phantom or real.
Bankruptcy and insolvency solutions
Two other circumstances offer tax relief in foreclosures, but both could cause other financial problems.
If a homeowner can show he's insolvent before the
discharge of the mortgage and turnover of the property, as well
as afterward, any proceeds are not taxed. However, says Trenholm,
"insolvency is a little tricky. There's no strict definition
of what assets (go in the calculation), but for the most part, a
lot of people caught in the real estate crunch can establish that
The other option is bankruptcy.
"Forgiveness debts, in these cases, are not taxed,"
says Roth. "They don't want the bank chasing them down, which
is why many times people going through foreclosure also go through
However, filing for bankruptcy has its own set of
considerations. "New bankruptcy rules don't give (filers) a
lot of relief," says William S. Bost, a member of the Raleigh,
N.C.-based law firm Ragsdale Liggett PLLC. "If you have a job
and are making money, the new bankruptcy rules don't give you a
whole lot of help. It gives you some time, but I don't think that's
necessarily the way to go.
"It used to be like going to church, you walk
in and walk out absolved, but it's not like that anymore,"
says Bost. "Now, it's not worth the pain you pay the rest of