TurboTax / Tax Calculators & Tips / All Tax Guides / Home Ownership / Home Foreclosure: What's Your Tax Liability?

Home Foreclosure: What's Your Tax Liability?

Updated for Tax Year 2014


OVERVIEW

Through 2014, exceptions to federal tax laws allow some homeowners to escape additional tax liability when going through foreclosure.


The experience of home foreclosure is difficult enough to endure without the headache of being held liable for federal income taxes assessed against the amount of money the forgiven debt represents. Exceptions to federal tax laws allow some homeowners to escape additional tax liability when going through foreclosure. Tax experts warn, however, that the exceptions may not be around forever.


 “You have to ask yourself some really difficult questions. 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.”

- Jim Thielen, senior partner of Thielen Plus Tax & Business Consulting, Tallahassee, Florida


 

Understand the exceptions

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."

Housing and Economic Recovery Act

Beyond the traditional insolvency exception, you may qualify for additional help under the 2008 Housing and Economic Recovery Act.

However, this exclusion ends in 2014.

Ask yourself two questions:

  • Is the foreclosure occurring on your principal residence?
  • Is your mortgage debt restricted to the purchase and improvement of your home?

If you answered “yes” to both, you’ll face no additional tax burden, says Linda Goold, tax counsel for the National Association of Realtors. A summer home on the beach is still subject to taxes. So is that refinancing you might have undertaken to pay for your daughter’s wedding.

The act was extended through the end of 2014. If you think you will be facing foreclosure in the near future, or if you are considering “short selling” your home for less than your mortgage balance, Goold says, “You jolly well better get your transaction under way as quickly as you possibly can” because processing such transactions can take months.

In other words, even if you go through most of the process in 2014, you will not benefit from any of the law’s exceptions if the transaction occurs in 2015, assuming the law expires.

Restructure your loan

Goold says there is another, lesser-known exception. The reason it is lesser known, perhaps, is that it is hard to take advantage of. In some circumstances, your bank may be willing to restructure your loan to reduce the principal. The government does not consider this taxable debt forgiveness, and it may just allow you to keep your home.

The problem, of course, is that banks might have difficulty seeing the benefit of writing off part of your debt. Goold says you may be in a good position to enter this kind of negotiation if your mortgage is with a local community bank where you have personal relationships.

“Banks don’t always get thrilled about it because they are just writing down capital,” she said. “I think it’s fair to generalize that if I have my mortgage with a local banker, or somewhere I’m known, that probably I’ll have a somewhat easier time restructuring my loan.”

Thielen says it is wise to verify the accuracy of your Form 1099-C, which lists debt forgiveness. The debt forgiveness is based on the fair market value of your home, but you are not required to accept the lender’s number. He also suggests you check your credit report to ensure the bank has actually released the debt.

“It should be off your credit report," Thielen said, "but people aren’t following through with that.”

Short Selling

Taking on an unaffordable mortgage is not the only way in which homeowners find themselves in regrettable situations. Many homeowners who are current on their payments find the home is worth less than the outstanding mortgage balance.

This no doubt is partly because of the tanked housing market, but it can also occur because of things outside of the homeowner's control.

"It can be where my lovely property is now a block and a half away from a new highway, and I can't cross that highway, so my property is now more stranded, so the value has gone down," says Linda Goold, tax counsel for the National Association of Realtors.

If you choose to "short sell" for less than your home is worth, you should be aware that banks will not process the transaction immediately. Goold says she knows a couple that attempted to purchase a home through a short sale. Eight months after the couple made an offer, the bank still had not recognized the transaction. The couple had to find another place and broke their contract on the short sale. Goold says she hears similar stories every day.

Get every deduction you deserve

TurboTax Deluxe searches more than 350 tax deductions and credits so you get your maximum refund, guaranteed.

For only $54.99*
Start for Free

The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.

* Important Offer Details and Disclosures
  • Try for Free/Pay When You File: TurboTax online and mobile pricing is based on your tax situation and varies by product. Actual prices are determined at the time of print or efile and are subject to change without notice. Special discount offers may not be valid for mobile in-app purchases.
  • TurboTax CD/Download products: Price includes tax preparation and printing of federal tax returns and free federal efile of up to 5 federal tax returns. Additional fees apply for efiling state returns. E-file fees do not apply to New York state returns. Prices subject to change without notice.
  • TurboTax Mobile: Actual prices are determined at the time of print or efile and are subject to change without notice. Come back here before you file to confirm that the price has not changed, especially if it's been a while since you downloaded this app.
  • Anytime, anywhere: Internet access required; standard message and data rates apply to download and use mobile app features and content. TurboTax mobile app devices supported include Android 4.1 and above, iOS 8 on iPhone 4s and above, and iPad 2.
  • Fastest refund possible: Fastest tax refund with efile and direct deposit; tax refund timeframes will vary.
  • Pay for TurboTax out of your federal refund: A $34.99 Refund Processing Service fee applies to this payment method. Prices are subject to change without notice.
  • About our TurboTax Product Experts: Customer service and product support (phone or chat) vary by time of year. Phone support not included with Free Edition.
  • About our credentialed tax experts: Live tax advice service is available for your toughest tax questions; fees may apply. Service, experience levels, hours of operation and availability vary, and are subject to restriction and change without notice. Click here for full terms and conditions. Not available for TurboTax Business customers.
  • Get up to 10% on top of your federal refund: Amazon.com Gift Card offer is for federal refunds only. Limits apply ($2000 per e-card, maximum $10,000 per customer). Offer available only for TurboTax Online (except Federal Free Edition) or CD/download versions sold and shipped, or downloaded directly from Intuit or Amazon. Except as required by law, Amazon.com Gift Cards cannot be canceled, transferred for value or redeemed for cash.

    Amazon.com is not a sponsor of this promotion. Except as required by law, Amazon.com Gift Cards ('GCs') cannot be transferred for value or redeemed for cash. GCs may be used only for purchases of eligible goods at Amazon.com or certain of its affiliated websites. For complete terms and conditions, see www.amazon.com/gc-legal. GCs are issued by ACI Gift Cards, Inc., a Washington corporation. All Amazon ®, ™ & © are IP of Amazon.com or its affiliates. No expiration date or service fees.
  • #1 best-selling tax software: Based on aggregated sales data for all tax year 2013 TurboTax products.
  • 4.8 out of 5 stars: Average based on customer ratings on TurboTax.com for TurboTax Online and CD/download products tax year 2014, as of January 2015.
  • Most Popular: TurboTax Deluxe is our most popular product among TurboTax Online users with more complex tax situations.
  • TurboTax CD/Download priority phone support: Priority phone support for TurboTax CD/Download Premier and Home & Business is accessible exclusively via the TurboTax.com Help Center.
  • Benefit Assist: After you file, TurboTax automatically shows you a full list of government benefits you may qualify for, like Food Stamps or reduced phone & utilities. Plus, we help you apply, saving you time and making it easier than ever to get more money! Estimate based on calculation of Benefit Assist users from tax year 2013 and published reports of average benefit and savings amounts from federal and state programs. Actual amounts and qualifications based on your individual situation; some individuals will not qualify. Feature may not be available for all customers.
  • Simplified State Experience: New, simplified state tax preparation available for most filers.
  • Eligibility for $25 cash back for returning Deluxe customers: Customers who have completed their 2013 taxes in TurboTax Deluxe (CD or download), and have completed their 2014 taxes in either TurboTax Premier or TurboTax Home & Business (CD or download), and apply here before 11:59PM PDT April 20, 2015, are eligible for $25 back. 2014 TurboTax Advantage users are ineligible for this offer. Terms and conditions are subject to change without notice.
  • $0 Upgrade Offer: Valid for customers who filed their 2013 taxes with TurboTax Deluxe (CD or download), completed prior year data transfer this year, and encounter an upgrade to either 2014 TurboTax Premier or 2014 TurboTax Home & Business (CD or download). Valid February 6, 2015 through April 20, 2015. TurboTax Advantage users are ineligible for this offer. This offer may not be combined with our $25 cash back offer. Terms and conditions are subject to change without notice.