Getting a tax bill after you have gone through a foreclosure is like pouring salt on the wound. You’ve lost your home and you probably don’t have much money so why would you owe the IRS anything?
Here’s why: The IRS treats forgiveness of debt as taxable income. For example, if you owe $300,000 on a home, it goes into foreclosure and the bank sells it for $200,000 and writes-off the rest of the loan, under the tax code the $100,000 of forgiveness of debt is taxable income.
In 2007 Congress enacted legislation that excludes up to $2,000,000 in forgiven mortgage debt from taxes as long as the loan was used to buy or improve your primary residence. Most people who lost their home to foreclosure last year won’t have to pay taxes on the cancelled debt.
However, there are limits to this relief. For example, the exclusion is scheduled to expire at the end of 2012. Important – banks and other lenders that write-off more than $600 of debt are required to send the borrower a Form 1099C. This form also goes to the IRS.
If you receive a 1099C for debt that was forgiven as a result of foreclosure you need to tell the IRS if it qualifies for the exclusion. To do this you would need to fill out a Form 982 on your Form 1040. Otherwise, the IRS could treat your forgiveness of debt as taxable income.
You can find more information at http://irs-taxdebthelp.com