That's right. Even though you aren't selling the house and the bank is, the IRS views the transaction as if you were the seller. That means you could owe taxes on the sale. The bad news comes directly from the IRS, via Publication 544:
"If you do not make payments you owe on a loan secured by property, the lender may foreclose on the loan or repossess the property. The foreclosure or repossession is treated as a sale or exchange from which you may realize gain or loss. This is true even if you voluntarily return the property to the lender. ... You figure and report gain or loss from a foreclosure or repossession in the same way as gain or loss from a sale or exchange. The gain or loss is the difference between your adjusted basis in the transferred property and the amount realized."
Those calculations also take into consideration any cancellation of debt income and the type of mortgage.
So yes, you could indeed pay tax on the money that was used to pay back the mortgage even though you don't get any of it.
The popular home sale gain exclusion 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 solutionsTwo 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 condition."
The other option is bankruptcy.
"Forgiveness debts, in these cases, are not taxed," says John W. Roth, senior tax analyst at CCH. "They don't want the bank chasing them down, which is why many times people going through foreclosure also go through bankruptcy."
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 your life."
For more tax-filing information and tips, check out Bankrate's Tax Guide.