If you will ultimately lose your home to foreclosure, it often makes sense to file for bankruptcy before the foreclosure sale is final to avoid a possible tax hit (or worse)—especially if you live in a state that allows for a deficiency judgment. Here’s why.
A deficiency is the difference between your mortgage balance and the foreclosure sale price (minus costs and fees related to the sale). For example, if you owed $400,000 on your mortgage, your home sold for $300,000, and the servicer incurred $10,000 to sell the property, you will owe a deficiency of $110,000 ($400,000 - $300,000 + $10,000). If you lose your home to foreclosure, you may end up owing a deficiency. (For more information, see What Is a Deficiency Judgement?) [LINK]
What happens next depends a lot on the state you live in so it is important to consult your local laws. For instance, in some states, such as California, lenders cannot collect deficiencies for a loan used to purchase the property, which is called a “recourse” or “purchase money” loan. But the same isn’t true for junior loans used for things other than buying the property, such as for remodeling or paying bills. The deficiency rules discussed below will apply. (Find out more by reading States That Prohibit Deficiency Judgments Following Short Sales.)
If your state allows a deficiency judgment, one of two things can happen—and both are financially unpleasant. Either your lender will try to collect the deficiency judgment from you using common collection techniques—such as instructing your employer to deduct money from your paycheck (a wage garnishment) or forcing your bank to drain your account (bank levy)—or the lender will forgive some, or all, of the debt.
If you pay the entire deficiency amount, you won’t incur a tax liability, but you’ll likely be out a significant sum of money. On the other hand, if your lender forgives the deficiency after the foreclosure sale, the government considers the forgiven debt to be taxable income, meaning that you must pay tax on this amount at the end of the year. If the amount of forgiven debt is large, you end up with a significant tax debt, especially if the extra “income” pushes you into a higher tax bracket. This situation can hit you especially hard if you and your lender agree that you can avoid foreclosure by selling the home for less than it’s worth in a process called a “short sale." Again, if the lender forgives a sizeable deficiency, you'll likely wind up with a sizeable tax bill, too.
During the height of the economic downturn, most homeowners didn’t need to worry about this tax hit because the Mortgage Forgiveness Debt Relief Act absolved people of tax liability for forgiven mortgage debt. The Act initially applied to debt forgiven from 2007 through 2012 and was extended twice after that. The program officially ended December 31, 2014.
(For more information, read The Ending of the Mortgage Forgiveness Debt Relief Act.) [LINK]
One of the benefits of filing for Chapter 7 bankruptcy before your home forecloses is that it wipes out the debt before any tax obligation attaches. By contrast, once you owe the tax, filing for bankruptcy alone won’t get rid of it. There are ways you might still be able to avoid paying it (for example, you meet certain criteria for insolvency), but you’ll need the help of an accountant or bankruptcy lawyer to handle the extra steps. Given the uncertainty, it might be better to avoid the tax problem altogether by timing your bankruptcy filing accordingly.