After writing this blog entry on the true costs of foreclosures, I came across this great SmartMoney.com article that I thought might be of interest to my readers. The post describes – in detail – the tax implications of foreclosures, and offers helpful advice on how to avoid them.
A foreclosure transaction occurs when a mortgage lender repossesses a borrower’s property and then sells it to pay off the debt. In most cases, however, a foreclosure will only happen when the mortgage debt exceeds the property's fair market value, or FMV. In this situation, the federal income tax rules treat the foreclosure as a sale for the FMV amount.
Therefore, a tax gain will result if the property’s FMV exceeds its tax basis. (The tax basis of a principal residence usually equals the original cost of the property, plus the cost of any improvements.) On the other hand, a tax loss will result if the property’s FMV is less than the tax basis.
If a mortgage lender also forgives some or all of the debt against your property in conjunction with or after the foreclosure transaction, you have cancellation of debt (COD) income. That income is taxable unless an exception applies.