Is it true that I could be taxed because of a home foreclosure?  Will I still be taxed if I file bankruptcy?

Yes and no, in that order.  But it's not quite that simple, so read on.

Thanks to the 16th Amendment, IRS gets to tax your income.  Since IRS expects that you will repay money you borrow, it does not tax income which is only a loan.  If a creditor forgives the loan and says, for whatever reason, you do not have to repay it, IRS changes its mind and taxes the loan as if it were ordinary income.  If IRS didn't do this an employer could make your wages tax-free by loaning your pay to you and later forgiving the loan.  (Those IRS guys are clever, aren't they?)

When a lender forecloses on a mortgage, it usually sells the home to the highest bidder at auction.  The lender may not get the full balance of the loan.  The portion of the loan that is not repaid by the foreclosure sale is the unsecured part of the loan or the deficiency.  Some states (Arizona, for example) limit the ability of a lender to come after the borrower for a deficiency on home loans.  If the lender forgives the deficiency because of state law or for other reasons, IRS will re-classify this part of the loan as income to you, and require that you pay income tax on it.

If you file bankruptcy (Chapter 7 or Chapter 13) before the foreclosure has been completed, the loan will be discharged.  You will no longer owe the loan, and there will be nothing for the creditor to forgive.  A bankruptcy filed soon enough will eliminate both the debt that you owe, and the tax on the deficiency.  [11-2-98]

This page was last revised: 10/11/16