Tax Consequences of Foreclosure

Foreclosure is one of the most frightening and demoralizing occurrences in a person’s life. At best, it is a massive setback to one’s credit; at worst, it can make your family homeless. On top of the emotional and mental toll, there can also be tax consequences after foreclosure, and there are also consequences if you experience foreclosure both before or immediately after a bankruptcy filing.

File Bankruptcy Before or After a Foreclosure?

The main question most people have is when to file: if you are certain that foreclosure will happen, is it better to file for bankruptcy before or after the foreclosure sale? The answer is almost always before, at least in today’s difficult economy.

The current economy and subsequently depressed housing market means that more often than not, when a house is sold, it is sold for less than the purchase price. This creates a deficiency, where the debtor still owes the difference between the foreclosure price and the mortgage. However, when someone files for bankruptcy after a foreclosure, the deficiency debt is wiped out. If you file before a foreclosure, you may be forgiven for the deficiency, but you will still owe a tax debt to the Internal Revenue Service (IRS).

Tax Debt and Foreclosure

Even if your lender forgives any deficiency on your foreclosure, you may still owe money, but instead of to your lender, it will be to the IRS. The IRS treats a forgiven debt as a windfall, and windfalls are generally frowned upon. As such, windfalls are usually taxed as income – it is, according to the IRS, money you received. However, there is one possible way to avoid such a tax bill – to qualify under the insolvency exception.

The insolvency exception is fairly straightforward – if you have more liabilities than assets at the time your debt was settled, you were insolvent and do not owe taxes on the income derived from the cancellation of the debt. The IRS is not interested in using time getting the proverbial blood from a stone. It may turn out to be difficult to define whether or not you were in fact insolvent at the exact time of the debt’s settlement, but the exception itself is clear cut – if you were insolvent at the time, you owe no tax on that debt; if you were not, you do. Keep in mind, however, that while income is taxable, debts discharged in some types of bankruptcy (most commonly Chapter 11) are not. It is not necessary to go into the question of exemptions unless you have experienced what the IRS considers a windfall.

There was, until recently, another possible way to exempt oneself from taxes due to cancellation of debt income. The Mortgage Debt Relief Act of 2007 was signed into law by President George W. Bush to help give homeowners a break at the height of the U.S. recession. It applied to forgiven mortgage debt only on one’s primary home, and was in effect from 2007 to early 2014, when it expired without renewal. Currently, another, similar bill is before Congress, but nothing has yet been approved.

A Professional Can Speed The Process

If you are going through foreclosure, sometimes the smartest move you can make is to call in a professional. The experienced attorneys at The Law Offices of Stephen B. Kass, P.C. have expertise in both bankruptcy and tax law, and we can put the full breadth of that knowledge to work for you. Call our New York City office today to discuss your options.