Taxes & Deed in Lieu of Foreclosure

Identification

The Internal Revenue Service considers canceled debt to be income, because releasing you from a debt obligation allows you to divert money to other expenses that normally would have went to debt payments. For example, if you give the bank a deed and it cancels, say, $30,000 on your mortgage, you pay taxes as if you earned that forgiven debt. Most states also charge a deed tax to transfer a property. This equals the higher of $1.65 or some percentage of the purchase price.

You might be able to offset taxes on canceled debt with a deduction in the depreciation of a property. You can only deduct the depreciation in the value of a home if you use it for business purposes, such as a rental unit. On the other hand, the IRS lets you ignore capital loss or gains on a foreclosure if you can prove insolvency. For instance, if you own $100,000 in assets and $150,000 in debt, the IRS won't tax you on the $50,000 in insolvency. You can also ignore canceled debt on taxes under the Mortgage Debt Relief Act of 2007, which lasts until 2013. If you see a capital gain on the foreclosure -- when the fair market value on the property goes up but you still owe money on it -- of a primary residence you can deduct up to $250,000 in capital gains, or $500,000 if filing a joint return.

Whether or not you owe canceled debt income depends in large part on the laws of your state and the specifics of the contract. In non-recourse loan states, a lender cannot go after a balance left over after a short-sale, deed in lieu of foreclosure or foreclosure. Thus, the IRS cannot tax you on forgiven debt, because there is none. Instead, the IRS taxes you on capital gains. The IRS uses the value of the mortgage as the selling price of the home in a non-recourse state. In recourse loan states, the IRS subtracts the loan balance from the fair market value to calculate tax liability. Some states, such as California, declare all mortgages non-recourse loans.

Review your contract to determine if you have a recourse or non-recourse loan. You may need an attorney to figure out which one you have. You should also hire a tax professional to calculate whether or not you are truly insolvent. If you want to use an insolvency exclusion, you must prove to the IRS that you have more liabilities than assets; determining the fair market value on certain assets, such as jewelry, is not always straightforward. If you receive canceled debt, the lender should send you a 1099-C, but you owe taxes on canceled debt regardless of whether or not the lender issues this form.