Foreclosure and Your Tax Bill

If you were among the millions of homeowners caught in the mortgage foreclosure fiasco or who if you have had your debt reduced through a mortgage restructuring, you may qualify for special tax relief when you file your 2008 tax return.

Normally, if a commercial lender cancels a portion of your mortgage debt through a transaction known as a "short sale" or your debt is wiped out in a foreclosure, the forgiven debt is considered taxable income. Congress approved legislation in 2007 that excludes up to $2 million of indebtedness if it is secured by a principal residence. Last year, lawmakers extended the homeowners' relief through 2012.

For example, say you bought a home several years ago for $500,000 and last year it was worth $350,000. But your mortgage balance was still $450,000 and on top of that, you lost your job. With no way to make the monthly mortgage payments and no hope of selling your house in a depressed real estate market, you hand the deed back to the bank and walk away.

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From a tax standpoint, two things happened. Your lender canceled $100,000 worth of debt and you realized a $150,000 loss on your house. Luckily, you qualify for the principal residence indebtedness provision and can exclude the $100,000 worth of canceled debt -- normally considered taxable include -- on your 2008 tax return.

Use Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) to report the cancellation of $100,000 worth of debt. You reduce the basis in your home by the same amount. So instead of a $150,000 loss on the sale of your home ($500,000 purchase price minus the $350,000 value at the time of foreclosure), you now have a $50,000 loss ($150,000 minus $100,000 in canceled debt.) It won't affect your taxes because losses on the sale of a principal residence are not deductible any way. Bottom line: the foreclosure has no impact on your 2008 tax bill.

The tax relief does not apply to vacation or other second homes or to "cash out" refinancing that went to pay for other purchases or to wipe out credit card debt. "It will only help those who borrowed too much to acquire, build or improve a principal residence," says Robin Christian, Senior Tax Analyst for the Tax & Accounting business of Thomson Reuters.

There are other exceptions, too. Seller-financed mortgages -- meaning the home’s prior owner loaned you money to buy the house -- are not covered by the cancellation of debt provision. And debts discharged through bankruptcy are not considered taxable income.