Due to the recent downturn in the U.S. real estate market, more homeowners are unable to maintain property mortgage payments, especially when they have an adjustable rate mortgage that may reset periodically at a higher interest rate. Due to the impact of higher mortgage payments combined with lower real estate values, many taxpayers are faced with foreclosure. As if that situation weren’t bad enough, often after completing the foreclosure, the taxpayer will receive an income tax notice indicating that federal tax is due related to the transaction.

A foreclosure may result in a tax liability in two situations.

First, when a property is foreclosed, it is treated as a sale for tax purposes. Therefore, if the fair market value of the property upon foreclosure is higher than the taxpayers adjusted basis in the property, taxable gain will result.

For instance, if a taxpayer originally purchased a residence for $200,000 and the property was worth $220,000 when foreclosed, the taxable gain upon the foreclosure is $20,000. The IRS section 121 gain on sale of residence exclusion is available for foreclosed property as long as the property was used both as a personal residence and owned for two out of the previous five years. As long as the requirements are met, the taxpaper needn't report a gain. However, if the taxpayer is ineligible for the section 121 exclusion, the gain upon sale must be reported as a taxable gain on schedule D of the taxpayer’s individual income tax return.

The second situation in which tax may result from a foreclosure is related to relief of debt income, which is calculated as the total amount of mortgage debt immediately prior to foreclosure minus the fair market value of the property.

Continuing with the example from above, if the taxpayer’s total mortgage debt upon foreclosure was $250,000, the taxpayer would report relief of debt income of $30,000 ($250,000 mortgage debt minus $220,000 fair market value on date of foreclosure). The taxpayer would receive form 1099-C from the lender that would report the fair market value of the property in box 7 and the amount of debt cancelled in box 2. The difference between these two amounts generally is the amount of income from debt relief.

Cancellation of debt income is not taxable in some cases. These include debts that are discharged through bankruptcy, debts that are discharged when you are insolvent, certain farm debts, and non-recourse loans. These exceptions usually are quite complex, so it is always a good idea to get professional advice if you are faced with this unpleasant situation.