Foreclosure starts in California were up 8% over the prior month in January, and the federal home foreclosure tax provisions that kept borrowers from both losing their homes and acquiring a whooping tax bill expired.
Extensions of the federal safe harbor have been introduced and may be retroactive if the act is extended, but homeowners facing possible foreclosure should have a plan should Congress not step up to the plate.
Tax on cancelled debt
The basic problem is that federal tax law treats debt that is forgiven or cancelled as if it were actual money in your pocket. The cancelled debt is added to the rest of your income for the year in which the cancellation takes place.
In the foreclosure situation, the measure of the debt that is cancelled is the difference between what you owe on the mortgage at foreclosure and the value of the property. In California, that difference could be hundreds of thousands of dollars.
At any marginal rate, that’s a kick in financial gut.
Beating the tax
The original, statutory exceptions to including cancelled debt in taxable income remain: insolvency and bankruptcy.
Insolvency can be tricky.
For the IRS purposes, the calculation includes not only your usual assets but also your retirement savings such as IRA’s, deferred comp plans, and 401(k). Your retirement may be money that your run-of-the-mill creditors can’t reach, but it is part of the insolvency calculation should you lose a home to foreclosure.
To claim an exclusion for cancelled debt, you file IRS form 982 . The worksheet for proving insolvency is part of the form.
Bankruptcy is the other big exception: if you file bankruptcy before the foreclosure sale, the debt is deemed forgiven by reason of the bankruptcy discharge.
A foreclosure sale after the bankruptcy is filed will transfer title to the buyer at the sale, but the associated debt is already forgiven.
Depending on the numbers, a bankruptcy just to avoid the tax consequences of a foreclosure outside of bankruptcy may be warranted.
More on tax issues