If you default on your mortgage payments, it’s possible that you will sell the property for less than you owe in a short sale or the lender will eventually foreclose. And if your lender forgives any remaining debt (called a "deficiency") after the short sale or foreclosure, it’s possible that you might have to pay income tax on the difference. 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 debt when it receives an IRS Form 1099-C from the lender. You'll get a copy too. This is a form on which a creditor reports income derived when repayment of a loan is no longer feasible—which would be the case in a short sale or foreclosure, or when the creditor writes off a debt.
Whether or not you’ll owe tax depends on the circumstances. Here are the basic rules.Loans for your principal residence. If you can meet the requirements under the Mortgage Forgiveness Debt Relief Act of 2007, you won't have to pay taxes on the forgiven debt. This Act allows taxpayers to exclude certain types of forgiven debt from their taxable income, as long as the forgiven debt was used to:
buy, build, or substantially improve a principal residence, or
This exclusion applies to debt that was forgiven in 2007 through 2017, or to debt that is discharged in 2018 if there was a written agreement entered into in 2017.
You can only exclude $1 million of forgiven debt, or $2 million if you are married and filing a joint tax return.
Loans for other real estate. If you default on a mortgage that’s secured by property that isn’t your primary residence, you’ll likely owe tax on any forgiven deficiency debt. So, for example, if you walk away from a loan on your second house in the country, expect a Form 1099 in the mail. The same is true for loans on non-residential real estate.
Loans not used for real estate. Similarly, if you take out a home equity loan and take that world trip you’ve been dreaming of instead of using the money to improve your house, you may end up on the wrong side of a tax bill.
EXAMPLE: Harry owes $200,000 on his second home, which is foreclosed and sold at auction for $150,000. The lender files an IRS Form 1099-C, reporting the $50,000 difference as cancelled, which means it is taxable income to Harry.
If you do face income tax liability, you have a few possible ways of getting out from under it including: the insolvency exclusion and bankruptcy.
Insolvency exclusion. 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.
Bankruptcy. Filing for bankruptcy works because debt wiped out (discharged) in bankruptcy has never been considered as taxable income. You’ll have to show that you filed for bankruptcy before the debt is forgiven. Of course, you’ll want to file for bankruptcy only if it otherwise makes sense.
You can fight back if an unpaid loan amount is treated as taxable income. If you receive a Form 1099-C attributing income to you from mortgage debt forgiveness, but you think you shouldn’t owe the tax, file IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your regular tax return. For example, if you receive a 1099-C for a debt discharged in bankruptcy, then you should file a Form 982 to the IRS indicating the bankruptcy filing.
Tax laws are complicated and there are exceptions and exclusions that could save you from having to report canceled debt as part of your income. If you have tax questions, consider talking to an attorney.