Forgiven Debt

• If your lender agrees to forgive any remaining debt after the sale of your foreclosed home, the lender is required to report the loan balance if it is more than $600, according to federal law. The forgiven amount is considered by the IRS to be income you would not have otherwise had if not for the debt forgiveness. The income is reported when the lender files Form 1099-C, Cancellation of Debt. If you fail to receive a Form 1099-C from the lender, you must still report the forgiven amount on your tax return.
  
  

Debt Relief Act

• If you have mortgage debt partially or completely forgiven in 2011 or 2012 because of foreclosure or loan restructuring, you may be eligible for special tax relief. The Mortgage Forgiveness Debt Relief Act allows up to $2 million of debt to be excluded from income tax and $1 million for married filing separately, for mortgage debt discharged on your principal residence. You will not qualify for the tax credit if the forgiven debt was a result of services performed for the lender. The discharge of debt must be directly related to your financial condition or a decline in your home's value.
  
  

Exceptions to the Rule

• If you did a cash-out refinance of your home loan before foreclosure and used the money to pay for vacations, a new car or credit cards or student loan debt, you may owe the IRS. Only money used for home improvement, along with costs incurred by refinancing your loan, will not be taxed. In the eyes of the IRS, only money used to improve your home added value to your home, thereby reducing the difference between your loan balance and the home's fair market value at the time of foreclosure. Even if your lender forgives any remaining debt, the IRS will look at the cash portion of the debt that you spent, as taxable income. The same considerations will be given to a home equity line of credit.
  
  

Other Tax Breaks

• There are additional circumstances under which income from the cancellation of debt may not be taxable. If you file for bankruptcy or can claim insolvency (that is, your debts exceed your income), any debts forgiven are not considered taxable income. Alternative tax credits for homeowners in foreclosure apply if your mortgage loan is a nonrecourse loan. With a nonrecourse loan, the lender's only option is to foreclose and take ownership of your property, when you default on mortgage payments. The lender cannot pursue you for any deficiency resulting from the sale of the home at auction and must forgive the balance. Forgiveness of debt because of a nonrecourse loan will generally not result in cancellation of debt income.