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Foreclosure, Cancelled Debt & Taxes

Foreclosure is a procedure which entails a mortgaged property being sold by the lender after a borrower defaults on payments. If the selling of the property does not satisfy the entire mortgage debt, the lender may get a deficiency judgment from court to recover the remaining amount.

Cancellation of Debt

If the debt is cancelled partially or fully by the lender, the forgiven debt is considered taxable income and must be reported by the borrower on his or her tax return. Unless the borrower qualifies for the income exclusion, taxes need to be paid on the amount of debt forgiven. Typically, the lender also needs to report the forgiven debt on Form 1099-C, Cancellation of Debt.

Exclusion

If you qualify for the exclusion, you need to file Form 982. Taxable cancellation of debt income is reported on the return as:

  • Non-business Debt – Form 1040 as other income
  • Sole Proprietorship – Schedule C or F as other income (if the debt is related to a sole proprietorship nonfarm or farm business)
  • Non-Farm Rental Activity – Schedule E as other rental income (if the debt is related to a nonfarm rental of real property)
  • Farm Rental Activity – Form 4835 to report rental income based on crops or livestock produced by a tenant

When Cancelled Debt is Not Taxable

A cancelled debt is not always taxable. The common situations where a cancelled debt is not taxed are:

  • Bankruptcy
  • Insolvency
  • Certain farm debts
  • Non-recourse loans

You should confirm the qualifying factors for the exclusion relating to your particular case. Non-payment of taxes on forgiven debt can lead to a tax debt.

Gain or Loss from Foreclosure

Profits or loss from a foreclosure sale should be calculated as such: The amount realized plus proceeds from the foreclosure payment minus the adjusted basis of property immediately before the foreclosure sale.