By Mike Stetzer
Homeowners who owed more on their mortgages than their house sold for during a foreclosure sale may be taxed on the difference if it is forgiven by their lenders.
Because of falling house values, many homeowners ended up letting their homes go into foreclosure and having the bank sell the house for less than they still owed on their mortgages. CNN reports that in the last quarter of 2010, 27 percent of homeowners with mortgages owed more than their homes were worth.
Even if the bank forgives the debtor the difference - known as a mortgage deficiency - the debtor may still be taxed on it, as it is treated like income by the Internal Revenue Service (IRS) under certain circumstances, CNN says.
Until Congress passed the Mortgage Forgiveness Debt Relief Act in 2007, any mortgage deficiency could be taxed by the IRS as wages, the news source says. Now, most homeowners are protected against being taxed on this sum, with certain exceptions.
If a homeowner had a vacation or investment property foreclosed, or any home that was not his primary residence for at least two of the previous five years, the homeowner will have to pay taxes on the mortgage deficiency. The former owners of a multi-million dollar home may also be on the hook - only the first $2 million of a mortgage deficiency can be exempt from taxation. Anything above that is treated as income, according to the news source.
While the first two exceptions may not apply to most Americans, others may. Those who refinanced their homes and used the cash they took out for anything other than home improvement, then went into foreclosure and had their houses sold for less than they still owed may also have to pay additional taxes. In that case, the money taken out and spent will be taxed as income, the news source says. The same reportedly holds true of home equity loans, and in both cases, homeowners will have to show receipts that document what the funds were spent on to get out of being taxed.
Even homeowners in these situations can still avoid the tax, says Kent Anderson, an Oregon-based tax expert. The forgiven debt can be discharged if the debtor files for personal bankruptcy, and he will not be taxed on it, Anderson explained.