Debt Cancellation

• The federal tax law treats a cancellation of debt that you benefit from as the receipt of ordinary taxable income. Ordinary income treatment applies only to debts for which you are personally liable and have an unconditional obligation to repay. A lender who cancels a debt must send you Form 1099-C that reports the portion of the canceled debt subject to taxation. There is no obligation for the lender to file the form with the IRS unless the amount of debt cancellation is $600 or more. However, you still must include those amounts on a tax return.
  
  

Personally Liable

• If you are personally liable for the remaining balance of a mortgage when the lender forecloses on a home, you must pay income tax on any portion of the balance the lender forgives. For example, if you obtain a $300,000 mortgage and at the time of foreclosure the value of the home is $200,000, you are responsible to repay the remaining $100,000. If the lender cancels $50,000 of it, you must report the $50,000 as taxable income on the current year's tax return.
  
  

Not Personally Liable

• Some mortgages limit the liability of a borrower to the value of the home. These mortgages state that in the event you default on the loan, the foreclosure of the home fully satisfies the entire mortgage. You are not personally liable on any outstanding amount the lender is unable to recover from the foreclosure sale of a home. In the above example, the $50,000 would not be a taxable cancellation of debt.
  
  

Calculating Loss

• You calculate the gain or loss on the foreclosure of a home differently depending on whether you are personally liable for the mortgage. For both types of loans, the tax basis of the home is equal to the amount you pay to purchase it, inclusive of settlement costs, regardless of whether you finance the purchase with a loan. For personally-liable loans, you subtract the tax basis from the smaller of the home's fair market value or the outstanding mortgage balance immediately before the foreclosure minus the amount you remain personally liable for immediately after. For mortgages that you are not personally liable, subtract the basis from the outstanding mortgage balance that exists immediately before the foreclosure. Regardless of the type of mortgage, taxpayers can never deduct any resulting loss from the sale of a home. However, you are responsible for tax if you realize a gain on the foreclosure.
  
  

Qualified Principal Residence

• If the foreclosure of a home results in a loss because the mortgage balance you are personally liable for exceeds the value of the home, you can exclude from taxable income any amount of debt the lender cancels if the mortgage was for the purchase of a qualified principal residence. A qualified residence is the main home that you regularly live in.