If you default on your mortgage, and you or your lender eventually sell the property for less than you owe on it in a short sale or a foreclosure auction, your lender may either go after you for the difference (called the deficiency) or forgive the debt. (In some states the lender is unable to sue you for the deficiency). If your lender forgives the debt, you may be asked to pay income tax on the amount of the forgiven debt. The theory is that you are receiving a gift of this amount, because you don’t have to pay it back.
The IRS learns of the forgiven deficiency when it receives an IRS Form 1099C from your lender. This is a form on which a creditor reports to the IRS as income the amount of a loan that they no longer expect to be repaid—such as in a short sale or foreclosure.
Whether or not you’ll owe income tax on the amount of a forgiven deficiency depends on your circumstances. Here are the basic rules.
If you do face income tax liability on cancelled mortgage debt, you have two possible ways of getting out from having to pay it: the insolvency exclusion and bankruptcy.
To use the insolvency exclusion, you’ll have to prove to the satisfaction of the IRS that your liabilities exceeded the value of your assets at the time your debt was cancelled. Cancelled debt is not included in income to the extent you were insolvent.
Filing for bankruptcy will help you avoid income tax liability for cancelled debt because debt wiped out (discharged) in bankruptcy is not considered taxable income. You will have to file for bankruptcy before your debt is cancelled. And, of course, you’ll want to file for bankruptcy only if it otherwise makes sense for you.
For more detailed information on how the IRS treats cancelled debts due to a foreclosure or short sale, see the IRS’s website page on The Mortgage Forgiveness Debt Relief Act and Debt Cancellation and IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.