If this happens, you are likely to face foreclosure. As your home is being used as collateral for the loan, the bank will repossess your home and sell it to cover the balance of the mortgage. (You may also face foreclosure if you have not kept up with your property insurance or have not paid your property taxes.)
The trauma you and your family experience when you lose your home to foreclosure will hopefully be relieved by easing the pressure of mounting mortgage bills. However, this does not always mean that you are free from the financial obligations associated with the property.
So, before you wipe the slate clean of mortgage-related debts, here's an overview of the tax implications of foreclosure.
Understanding foreclosed mortgage debt
When your home is foreclosed on, you will have what is known as a foreclosed mortgage debt. Simply put, this means that you will no longer have to pay your debt, i.e. the mortgage.
However, it is important to understand that the IRS considers most cancelled debt to be income because you do not have to pay the additional amount owed on the loan to benefit.
"When a mortgage or any other debt is forgiven, the IRS treats the reduction of that debt as 'phantom income,'" says Bruce Ailion, an attorney and real estate expert with Re/Max Town & Country in Atlanta, Georgia." And phantom income is taxed as ordinary income, just as if you were receiving income to pay off a loan."
As a result, you may be subject to federal taxes on the debt you are forgiven. If so, you will receive a Form 1099-C ("Cancellation of Debt") from your lender showing the amount of debt cancelled.
This figure should equal the difference between your total final mortgage balance and the sale price of the home received by the lender.
However, even though the cancelled debt is technically considered income, this does not mean that you must pay tax on that income.
The Mortgage Debt Relief Act and the Foreclosure Date
Congress passed the Mortgage Debt Relief Act of 2007 at the beginning of the housing crisis of that era to exclude forgiven mortgage debt from income taxation as long as the taxpayer met certain requirements.
The Act has expired and then been extended several times by Congress (under the name of the Consolidated Appropriations Act).
"And, there will be no taxable income for cancelled debt under the Consolidated Appropriations Act (CAA), which was signed into law in December 2020 and extends the exclusion of cancelled qualified mortgage debt from income to tax years 2021 through 2025," said Dr. Lei Han, CPA and associate professor of accounting at Niagara University in New York.
As of now, the relief covers foreclosures through Dec. 31, 2025. So if you face foreclosure in 2026, you may be forced to pay income taxes on the forgiven debt unless Congress chooses to extend the bill again.
Currently, there are two main requirements that need to be met in order to have mortgage debt forgiven for income tax purposes:
The property must be your principal residence.
For joint filers, the amount of debt forgiven must be less than $750,000.
Home Equity Loans and Debt Relief
If you refinanced your home, took out a home equity loan or home equity line of credit, and then went through foreclosure, the amount of debt forgiven on that loan may still be taxable income.
The IRS considers refinancing loans, second mortgages and borrowing against your home's equity to be "recourse" loans, meaning that your lender can reclaim payment of the debt even after your home has been sold.
However, if your home equity loan or even your refinancing is for substantial improvements to your primary residence, the debt on these loans may qualify for tax-free treatment.
Other ways to avoid paying taxes on your debt
If you are required to pay taxes on the amount of debt that was forgiven because the foreclosed home was not your primary residence or your mortgage was a refinance or home equity loan, you may be able to reduce your tax liability in other ways.
For example, if the cancelled debt was due to a bankruptcy filing rather than a simple foreclosure, then your forgiven debt is not considered income.
Another possible solution is that you may have been considered insolvent before your mortgage debt was cancelled, meaning that your debt exceeded the value of all your assets, not just your home. You can then exclude the cancelled debt from your income tax up to the amount you are unable to pay.
As with any tax issue, you should consult a professional tax advisor who can work with you on your individual situation so that you are in compliance with IRS regulations.
In the case of a foreclosure, a housing counselor can also advise you on the tax implications of losing your home to a lender.