Are debts discharged on foreclosed properties taxable?

Are debts discharged on foreclosed properties taxable?

By Atty. Crispin Caday Lozano

The general rule is that discharge or forgiveness of debt represents income and is subject to tax unless exemption applies.  The difference between the second mortgage loan and the value of the property represents income subject to tax in the event of foreclosure.  However, if you file bankruptcy, the income derived as a result of foreclosure is not taxable.

Question:         My house is my primary residence, which was underwater when it was foreclosed.  Am I subject to tax on the difference between loan amount and property value?

Answer:           If the house is your principal residence, any income derived as a result of foreclosure is not taxable under a special law passed by Congress.   This law will expire December 31, 2012.  However, if the debt is used to buy, build or substantially improve the home, you may not qualify for this exemption.  A good example is if the house is refinanced.  The difference between the refinanced loan and the value of the property will be taxable.

Question:         What other situation may cancellation of debt is deemed not taxable?

Answer:           The other exemption on the taxability of cancelled debt is insolvency.  Any income derived on cancelled debt is not taxable if a person is insolvent.  A person is insolvent if the person’s liability exceeded his assets.  In determining assets for insolvency purposes, a person’s 401k must be included in the list of properties and everything you own.  Liabilities include almost everything you owe.

Question:         My second home has been foreclosed and I received a Form 1099c from the bank for the difference between the amount I owe and the fair market value of the house.  Should I file for bankruptcy?

Answer:           Yes.  The best way to resolve the issue that you made an income on the forgiven indebtedness is to consult with a bankruptcy attorney who will evaluate if you need to file bankruptcy.

Question:         I filed bankruptcy after my second home was foreclosed and I still got a Form 1099c for the cancelled debt.  Should I include this as taxable income?

Answer:           If you already filed for bankruptcy, you qualify for the exemption but still you have to report in your income tax return the amount of forgiven debt that is exempt from income tax because of your filing bankruptcy.  You should consult with a bankruptcy attorney to help you report this matter in your tax return.

Note:   This is not a legal advice and you need to speak to an attorney.  The Law Offices of Crispin C. Lozano has 16 years of experience in bankruptcy cases. 

Bankruptcy Basics

  1. Bankruptcy will actually improve your credit within one year because your unsecured debts are discharged. Although the bankruptcy will be in your records for 10 years, not filing bankruptcy will make your credit even worse until most your debts are paid.
  2. If you are being sued by your creditors, most money judgment can be eliminated in bankruptcy.
  3. Collection actions continue and you can be sued if you are in debt settlement.
  4. Chapter 7 will eliminate all unsecured debts. If you are near retirement age, you must eliminate most of your debts.
  5. Bankruptcy will stop foreclosure actions. If your trustee sale date is 10 days before, you can still file for bankruptcy.
  6. If your salary is being garnished, you have a court case about debts or you are being harassed by creditors, bankruptcy can stop garnishment, court cases, harassing creditors and eliminate the debt.
  7. Bankruptcy is cheaper, faster and safer than debt settlement which has no guaranteed success.
  8. Preserve your health, eliminate stress and live a happy life by eliminating your debts which is the root of all problems.

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