Home Foreclosures and Taxes

Some homeowners who faced foreclosure this year when they could no longer afford to make payments on a house worth less than its mortgage balance will get a break on their 2008 income taxes.

For example, say you bought a home a few years ago and paid $500,000. As a result of the real estate meltdown, the house is now worth $350,000. But your mortgage balance is $450,000, and you've lost your job. With no way to pay your bills and no hope of selling your house for enough money to pay off the mortgage balance, you hand the deed back to the bank and walk away. The bank sells the house for $350,000 and forgives the $100,000 balance remaining on the loan.

Normally, if any part of your mortgage is forgiven, it is considered taxable income. But the Mortgage Relief Act passed in 2007 will help mitigate the financial crisis for many distressed homeowners this year by excluding canceled mortgage debt from taxable income. Congress recently extended the provision through 2012.

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To qualify for what's called the principal-residence-indebtedness exclusion, the debt must have been incurred to buy, build or improve your primary home. The exclusion does not apply to second mortgages or to home-equity loans that were used for purposes other than to improve your home (such as wiping out credit-card debt or paying for your child's college tuition). The tax-free provision also excludes mortgages for vacation homes.

Although the foreclosure will not affect your income taxes, you still need to report the cancellation of debt on a special form -- Form 982 -- and attach it to your 2008 tax return.

"The cancellation-of-debt exclusion for principal-residence indebtedness may well save the day if your home was foreclosed on in 2008," says Robin Christian, senior tax analyst for the tax and accounting business of Thomson Reuters. "But often foreclosure is a drawn-out, painful process, occurring in several stages over more than one year," says Christian. "That's where your tax professional can be instrumental in getting the best results."