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FORECLOSURE AND BANKRUPTCY

Foreclosure Debt Is Not Written Off

Written By:
April 08, 2010 at 10:55 AM

Prior to legislation in 2007, debt for any home reclaimed by a lender through foreclosure was not written off. Instead, the lender issued to the foreclosed homeowner and the Internal Revenue Service (IRS) a Cancellation of Debt, Form 1099-C, which indicated the debt was canceled by the lender and specified the amount for which the debt was canceled. The IRS, in turn, expected the previous homeowner to pay taxes on the canceled debt amount indicated on the form, since the IRS considered the canceled debt to be income.

The hardship placed on homeowners who refinanced their mortgages or lost their homes through foreclosure, and were subject to taxable canceled income, was brought to the attention of legislators. As a result, on December 20, 2007, Congress successfully fast-tracked the passage of the Mortgage Forgiveness Debt Relief Act of 2007.

What does that mean for homeowners across America? Provisions made to the act generally denote that homeowners of a primary residence who have been foreclosed on may not have to pay tax on the canceled debt. Due to the mounting numbers of foreclosures, law makers saw the need to provide relief to homeowners struggling in default.

In contrast, if the home is not a primary residence and is foreclosed on by the mortgage holder, then the IRS will impose taxes on the total amount of the canceled debt. The property foreclosed on must have been the homeowner’s primary residence.

There are some exceptions to the rule of having to pay taxes on canceled debt.

Taxes are not imposed on certain farm debts considered canceled debt. Bankruptcy and insolvency are also situations where tax is not imposed on the cancellation of debt income for defaulted loans like a foreclosure. Another notable exception related to foreclosed home loans is in the case of what the IRS terms a “non-recourse loan.”

A non-recourse loan, as it applies to real estate, is one where the lender has no way to collect on funds borrowed to secure the home loan, where the borrower is in default. The lender’s only recourse is to reclaim through foreclosure the property used as collateral.

Basically, debt forgiveness for a non-recourse loan as a result of a foreclosure doesn’t become taxable canceled debt income. According to the IRS, the difference between what the previous homeowner of a primary residence paid down on the principle and the current fair market value of the home is considered “forgiven debt” for a non-recourse loan. Taxes are typically not imposed on forgiven debt; although, there are some exceptions.

For property owners who do not use their homes as primary residences and go through foreclosure, taxes will be owed on the canceled debt. Commercial property, rental property, vacation homes, a storage building or other property reclaimed by the lender through foreclosure will be considered a cancellation of debt and will be taxed by the IRS. In addition, if a mortgage was refinanced to pay for a vacation, medical bills, a child’s college or anything else not related to investing in the home, that amount will be considered canceled debt and will be taxed. It will not be written off.

Homeowners are not eligible for debt forgiveness if the foreclosure is not related to the homeowner’s financial situation or the decline in the value of the home. Those who are wondering if their debt will be forgiven, instead of being taxed as canceled debt, should contact a tax accountant or the IRS, or visit the IRS website for more information.

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