If your house is being foreclosed on, don’t expect the pain to end with the foreclosure.
You still have to deal with the IRS.
The IRS considers canceled debt as income, according to the New York Times:
Foreclosure is one way that beleaguered homeowners can fall into this tax trap. The other is when homeowners are forced to sell their homes for less than the value of the mortgage. If the lender forgives that difference, they are liable for income taxes on that amount.
The 1099 shortfall, as it is called, stems from an Internal Revenue Service policy that treats forgiven debt of all types as income even if the taxpayer has nothing tangible to show for it, unless the debt is canceled through bankruptcy.
The Center for Responsible Lending expects that 20 percent of the home loans made in 2005 and 2006 to people with weak credit, commonly called subprime loans, will end in foreclosure. Because so little money was required as a down payment during the boom, the value of many of these houses may be less than what is owed.
Some people in this predicament are fighting the I.R.S. and winning. Sometimes, lower payments can be negotiated with the I.R.S., tax experts say.
The idea seems counterintuitive, but that doesn’t change it:
“Your home has declined in value and you lose it,” Mr. Eggert said. “Then the I.R.S. says you owe tens of thousands in taxes because you got a windfall when the debt was forgiven.”
One way to fight the tax bill is to prove that the home was worth more than you owed on it when it was taken away. Another way is through bankruptcy. If you’re completely broke, you can also try to prove “insolvency.” If your debts are still greater than all your assets, the IRS might leave you alone.