When filing bankruptcy, petitioners can use the process to either keep the bank from taking their homes or completely eliminate their financial responsibility for them. When weighing the options, it's important to consider all factors involved, and one that's often overlooked is the tax liabilities you may incur after undergoing foreclosure. Here's more information about this issue and what you can do to protect yourself.
Canceled Debt Is Taxable
You may be surprised to learn that canceled debt is considered taxable income by the IRS. Since the lender gave the debtor money and then told them they don't have to repay it, the tax agency lumps that person in the same category as someone who receives an unexpected windfall. Thus, they are required to report the canceled debt as income and pay any taxes due on the amount.
In the case of home foreclosure, any leftover amount not covered by the sale of the home and written off by the bank is potentially considered taxable income. For instance, you owed $250,000 but the home sold for $200,000. If the bank forgives the $50,000 still due on your account, you would need to report that to the IRS as income.
Luckily, there are exceptions. Specifically, debt discharged in bankruptcy is not considered taxable income. So, using Chapter 7 bankruptcy to eliminate a mortgage means you won't have to worry about any residual balance coming back to haunt your tax returns.
However, because each financial situation is different, it's best to talk to a bankruptcy attorney about your particular circumstances to see how filing a petition will impact you.
Gains from Increased Property Value Are Taxable
Another possible consequence of home foreclosure is you might have to pay taxes on any increased property value. For example, if your house was worth $100,000 when you bought it but is now valued at $250,000, the IRS may tax you on the $150,000 difference regardless of how much you actually owe the bank.
Unfortunately, the opposite isn't true, and you can't write off your losses if your home's market value drops below what it appraised for when you bought it. However, if the home was your primary residence and the gain was less than $250,000 ($500,000 for married couples), you may be exempt from having to report this on your taxes.
If you don't qualify for the exemption, talk to a bankruptcy lawyer about other ways you can use the courts to reduce this tax liability or avoid it altogether. If the home is sold as part of a bankruptcy procedure, the IRS may let you use the home's sale price rather than the market value in your calculations, for instance.
For more information about how bankruptcy can help you with mortgage woes, contact a local attorney.