A longstanding principle of tax law treats any type of debt forgiveness as a financial benefit, even if it comes at the expense of your home. This means that even if you are facing foreclosure you may incur an additional debt to the government, either in the form of Cancellation of Debt Income, or in the form of Gain from Foreclosure.
“Some people refer to that as phantom income because no cash is trading hands,” says Rob Dietz, a housing economist with the National Association of Home Builders.
It is up to you to know what exceptions can eliminate the burden of Cancellation of Debt income. For example, debt forgiveness is not taxable if you’re insolvent. If you’re filing for bankruptcy and going through home foreclosure at the same time, you may not need to worry about additional tax liability. There is a distinction between those who can't avoid foreclosure and those who choose foreclosure as an escape from a bad investment.
“The only people I see getting burned by this have significant other investments,” says Jim Thielen, senior partner with Tallahassee, Florida-based Thielen Plus Tax & Business Consulting. “They are making a decision to let it go instead of paying for a bad asset.”
But, Thielen says, insolvency typically carries strict definitions. For example, you may not be considered broke if you are due a pension upon retirement, even if you can’t access the pension right now.
If you are considering walking away from your home — choosing foreclosure — Thielen recommends pausing for a moment. Walking away, he says, is not so easy.
"You have to ask yourself some really difficult questions," Thielen said. "Are you comfortable going six months without making a payment and dealing with the stress related to that? Just envision the number of calls you'll get."